Tronox Limited (NYSE:TROX) is currently trading at a trailing P/E of 51.7x, which is higher than the industry average of 25.8x. While this makes TROX 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 Tronox
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 TROX
Price-Earnings Ratio = Price per share ÷ Earnings per share
TROX Price-Earnings Ratio = 21.1 ÷ 0.408 = 51.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to TROX, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 51.7x, TROX’s P/E is higher than its industry peers (25.8x). This implies that investors are overvaluing each dollar of TROX’s earnings. As such, our analysis shows that TROX represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that TROX should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to TROX, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with TROX, 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 TROX to are fairly valued by the market. If this is violated, TROX's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to TROX. 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.