Compact Metal Industries Ltd (SGX:T4E) is trading with a trailing P/E of 35.5x, which is higher than the industry average of 23.8x. While T4E 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 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 Compact Metal Industries

Breaking down 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 T4E

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

T4E Price-Earnings Ratio = SGD0.04 ÷ SGD0.001 = 35.5x

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 T4E, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 35.5x, T4E’s P/E is higher than its industry peers (23.8x). This implies that investors are overvaluing each dollar of T4E’s earnings. As such, our analysis shows that T4E represents an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your T4E shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to T4E, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with T4E, 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 T4E to are fairly valued by the market. If this does not hold true, T4E’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

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.