Tribune Resources Limited (ASX:TBR) is currently trading at a trailing P/E of 11.6x, which is lower than the industry average of 19.6x. 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. View our latest analysis for Tribune Resources
What you need to know about 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for TBR
Price per share = 7.5
Earnings per share = 0.647
∴ Price-Earnings Ratio = 7.5 ÷ 0.647 = 11.6x
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 TBR, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since TBR's P/E of 11.6x is lower than its industry peers (19.6x), it means that investors are paying less than they should for each dollar of TBR's earnings. As such, our analysis shows that TBR represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy TBR, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to TBR. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with TBR, then investors would naturally value TBR at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with TBR, investors would also value TBR at a lower price since it is a lower growth investment. Both scenarios would explain why TBR has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing TBR to are fairly valued by the market. If this assumption is violated, TBR's P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on TBR, the undervaluation of the stock may mean it is a good time to top up on 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 TBR, 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 Tribune Resources 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.