T&G Global Limited (NZSE:TGG) is trading with a trailing P/E of 20.4x, which is higher than the industry average of 14.1x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for T&G Global

Demystifying the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for TGG

Price-Earnings Ratio = Price per share ÷ Earnings per share

TGG Price-Earnings Ratio = NZ$3.28 ÷ NZ$0.161 = 20.4x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to TGG, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. TGG’s P/E of 20.4x is higher than its industry peers (14.1x), which implies that each dollar of TGG’s earnings is being overvalued by investors. As such, our analysis shows that TGG represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your TGG shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to TGG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with TGG, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing TGG to are fairly valued by the market. If this is violated, TGG’s P/E may be lower than its peers as they are actually overvalued by investors.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.