Thorney Technologies Ltd (ASX:TEK) trades with a trailing P/E of 3.8x, which is lower than the industry average of 10x. While TEK might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Thorney Technologies

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 TEK

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

TEK Price-Earnings Ratio = A$0.27 ÷ A$0.072 = 3.8x

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 TEK, 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. TEK’s P/E of 3.8x is lower than its industry peers (10x), which implies that each dollar of TEK’s earnings is being undervalued by investors. Therefore, according to this analysis, TEK is an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy TEK, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to TEK. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with TEK, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing TEK to are fairly valued by the market. If this does not hold true, TEK’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

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.