Transit-Mixed Concrete Ltd (SGX:570) is currently trading at a trailing P/E of 72.1x, which is higher than the industry average of 23.2x. 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 Transit-Mixed Concrete

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief 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 570

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

570 Price-Earnings Ratio = SGD0.46 ÷ SGD0.006 = 72.1x

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 570, 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. 570’s P/E of 72.1x is higher than its industry peers (23.2x), which implies that each dollar of 570’s earnings is being overvalued by investors. Therefore, according to this analysis, 570 is an over-priced stock.

A few caveats

Before you jump to the conclusion that 570 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to 570, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 570, 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 570 to are fairly valued by the market. If this does not hold true, 570’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.