Marten Transport Ltd (NASDAQ:MRTN) is currently trading at a trailing P/E of 32.8x, which is higher than the industry average of 28.3x. 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Marten Transport
Breaking down 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 MRTN
Price-Earnings Ratio = Price per share ÷ Earnings per share
MRTN Price-Earnings Ratio = 20.55 ÷ 0.627 = 32.8x
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 MRTN, 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 32.8x, MRTN’s P/E is higher than its industry peers (28.3x). This implies that investors are overvaluing each dollar of MRTN’s earnings. Therefore, according to this analysis, MRTN is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your MRTN 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 MRTN. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with MRTN, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing MRTN to are fairly valued by the market. If this is violated, MRTN's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on MRTN, 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.