GTN Limited (ASX:GTN) is trading with a trailing P/E of 92.3x, which is higher than the industry average of 18x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for GTN

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 GTN

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

GTN Price-Earnings Ratio = A$2.68 ÷ A$0.029 = 92.3x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GTN, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since GTN’s P/E of 92.3x is higher than its industry peers (18x), it means that investors are paying more than they should for each dollar of GTN’s earnings. As such, our analysis shows that GTN represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your GTN shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GTN. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with GTN, 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 GTN to are fairly valued by the market. If this does not hold true, GTN’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? Since you may have already conducted your due diligence on GTN, 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.

Are you a potential investor? If you are considering investing in GTN, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on GTN for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.