TOR Minerals International Inc (NASDAQ:TORM) is trading with a trailing P/E of 81.9x, which is higher than the industry average of 25.8x. While TORM might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, 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 TOR Minerals International

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. 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 TORM

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

TORM Price-Earnings Ratio = 7.7 ÷ 0.094 = 81.9x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as TORM, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 81.9x, TORM’s P/E is higher than its industry peers (25.8x). This implies that investors are overvaluing each dollar of TORM’s earnings. Therefore, according to this analysis, TORM is an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your TORM shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to TORM, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with TORM, 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 TORM to are fairly valued by the market. If this does not hold, there is a possibility that TORM’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on TORM, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.

Are you a potential investor? If TORM has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on TOR Minerals International for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.