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Tesco PLC (LSE:TSCO) trades with a trailing P/E of 36.7x, which is higher than the industry average of 21.9x. While this makes TSCO appear like a stock to avoid or sell if you own it, 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. Check out our latest analysis for Tesco
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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 pound of the company’s earnings.
P/E Calculation for TSCO
Price-Earnings Ratio = Price per share ÷ Earnings per share
TSCO Price-Earnings Ratio = £2.06 ÷ £0.056 = 36.7x
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 TSCO, 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. Since TSCO’s P/E of 36.7x is higher than its industry peers (21.9x), it means that investors are paying more than they should for each dollar of TSCO’s earnings. Therefore, according to this analysis, TSCO is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your TSCO shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to TSCO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with TSCO, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing TSCO to are fairly valued by the market. If this does not hold, there is a possibility that TSCO’s P/E is lower because our peer group is 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.