Over the Wire Holdings Limited (ASX:OTW) trades with a trailing P/E of 31.1x, which is higher than the industry average of 28x. 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Over the Wire Holdings
Breaking down the P/E 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 OTW
Price-Earnings Ratio = Price per share ÷ Earnings per share
OTW Price-Earnings Ratio = A$3 ÷ A$0.097 = 31.1x
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 OTW, 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. OTW’s P/E of 31.1x is higher than its industry peers (28x), which implies that each dollar of OTW’s earnings is being overvalued by investors. Therefore, according to this analysis, OTW is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your OTW 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 OTW. 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 OTW, 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 OTW to are fairly valued by the market. If this does not hold, there is a possibility that OTW’s P/E is lower because our peer group is 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.