TAT Technologies Ltd (NASDAQ:TATT) is trading with a trailing P/E of 22.3x, which is lower than the industry average of 25x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, 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 TAT Technologies

Demystifying 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 TATT

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

TATT Price-Earnings Ratio = 10.8 ÷ 0.485 = 22.3x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as TATT, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. TATT’s P/E of 22.3x is lower than its industry peers (25x), which implies that each dollar of TATT’s earnings is being undervalued by investors. Therefore, according to this analysis, TATT is an under-priced stock.

A few caveats

While our conclusion might prompt you to buy TATT immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to TATT, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with TATT, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing TATT to are fairly valued by the market. If this does not hold true, TATT’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on TATT, the undervaluation of the stock may mean it is a good time to top up on 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.

Are you a potential investor? If you are considering investing in TATT, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on TAT Technologies for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.