Compact Metal Industries Ltd (SGX:T4E) is currently trading at a trailing P/E of 36.1x, which is higher than the industry average of 22.9x. 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Compact Metal Industries
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. 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 T4E
Price-Earnings Ratio = Price per share ÷ Earnings per share
T4E Price-Earnings Ratio = SGD0.04 ÷ SGD0.001 = 36.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to T4E, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 36.1x, T4E’s P/E is higher than its industry peers (22.9x). This implies that investors are overvaluing each dollar of T4E’s earnings. As such, our analysis shows that T4E represents an over-priced stock.
Assumptions to be aware of
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 compared higher growth firms with T4E, 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 T4E to are fairly valued by the market. If this does not hold, there is a possibility that T4E’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on T4E, the overvaluation of the stock may mean it is a good time to reduce 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: