Rio Tinto Limited (ASX:RIO) is trading with a trailing P/E of 14.8x, which is higher than the industry average of 11.1x. While RIO 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 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 Rio Tinto

Breaking down the Price-Earnings ratio

A common ratio used for relative valuation is the P/E ratio. 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 RIO

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

RIO Price-Earnings Ratio = 65.47 ÷ 3.455 = 14.8x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to RIO, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 14.8x, RIO’s P/E is higher than its industry peers (11.1x). This implies that investors are overvaluing each dollar of RIO’s earnings. As such, our analysis shows that RIO represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your RIO shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to RIO, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with RIO, 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 RIO to are fairly valued by the market. If this does not hold, there is a possibility that RIO’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to RIO. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.

Are you a potential investor? If you are considering investing in RIO, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.