This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between TPG Telecom Limited (ASX:TPM)’s fundamentals and stock market performance.
TPG Telecom Limited (ASX:TPM) is currently trading at a trailing P/E of 12.3x, which is lower than the industry average of 21.8x. While this makes TPM appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for TPG Telecom
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 TPM
Price-Earnings Ratio = Price per share ÷ Earnings per share
TPM Price-Earnings Ratio = A$5.29 ÷ A$0.430 = 12.3x
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 TPM, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. TPM’s P/E of 12.3x is lower than its industry peers (21.8x), which implies that each dollar of TPM’s earnings is being undervalued by investors. As such, our analysis shows that TPM represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy TPM immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to TPM, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with TPM, 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 TPM to are fairly valued by the market. If this does not hold, there is a possibility that TPM’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to TPM. 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. 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: