Thomas Cook (India) Limited (NSEI:THOMASCOOK) trades with a trailing P/E of 112.9x, which is higher than the industry average of 39.2x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Thomas Cook (India)

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for THOMASCOOK

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

THOMASCOOK Price-Earnings Ratio = ₹273.65 ÷ ₹2.423 = 112.9x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to THOMASCOOK, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since THOMASCOOK’s P/E of 112.9x is higher than its industry peers (39.2x), it means that investors are paying more than they should for each dollar of THOMASCOOK’s earnings. Therefore, according to this analysis, THOMASCOOK is an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your THOMASCOOK shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to THOMASCOOK. 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 THOMASCOOK, 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 THOMASCOOK to are fairly valued by the market. If this is violated, THOMASCOOK’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in THOMASCOOK. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: