Thorn Group Limited (ASX:TGA) trades with a trailing P/E of 4.8x, which is lower than the industry average of 14.6x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Thorn Group
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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 dollar of the company’s earnings.
P/E Calculation for TGA
Price-Earnings Ratio = Price per share ÷ Earnings per share
TGA Price-Earnings Ratio = 0.79 ÷ 0.163 = 4.8x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to TGA, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since TGA’s P/E of 4.8x is lower than its industry peers (14.6x), it means that investors are paying less than they should for each dollar of TGA’s earnings. As such, our analysis shows that TGA represents an under-priced stock.
A few caveats
Before you jump to the conclusion that TGA is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to TGA, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with TGA, 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 TGA to are fairly valued by the market. If this does not hold true, TGA’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of TGA to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If TGA has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.