I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Telstra Corporation Limited (ASX:TLS) is currently trading at a trailing P/E of 10.2x, which is lower than the industry average of 28.8x. While this makes TLS appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.

See our latest analysis for Telstra

Breaking down the P/E 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 TLS

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

TLS Price-Earnings Ratio = A$3.06 ÷ A$0.300 = 10.2x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to TLS, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. TLS’s P/E of 10.2 is lower than its industry peers (28.8), which implies that each dollar of TLS’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 8 Telecom companies in AU including TPC Consolidated, TPG Telecom and Macquarie Telecom Group. You can think of it like this: the market is suggesting that TLS is a weaker business than the average comparable company.

Assumptions to watch out for

However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to TLS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with TLS, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing TLS to are fairly valued by the market. If this is violated, TLS’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Since you may have already conducted your due diligence on TLS, 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: