Technology One Limited (ASX:TNE) trades with a trailing P/E of 37x, which is higher than the industry average of 32.1x. 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. View our latest analysis for Technology One

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 TNE

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

TNE Price-Earnings Ratio = A$5.24 ÷ A$0.142 = 37x

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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to TNE, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 37x, TNE’s P/E is higher than its industry peers (32.1x). This implies that investors are overvaluing each dollar of TNE’s earnings. As such, our analysis shows that TNE represents an over-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to sell your TNE shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to TNE, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with TNE, 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 TNE to are fairly valued by the market. If this is violated, TNE’s P/E may be lower than its peers as they are actually overvalued by investors.

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.