TSR Inc (NASDAQ:TSRI) trades with a trailing P/E of 30x, which is lower than the industry average of 33.4x. While this makes TSRI appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 TSR
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 TSRI
Price per share = 4.1
Earnings per share = 0.137
∴ Price-Earnings Ratio = 4.1 ÷ 0.137 = 30x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to TSRI, 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 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 TSRI's P/E of 30x is lower than its industry peers (33.4x), it means that investors are paying less than they should for each dollar of TSRI's earnings. Therefore, according to this analysis, TSRI is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy TSRI immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to TSRI. 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 TSRI, then investors would naturally value TSRI at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with TSRI, investors would also value TSRI at a lower price since it is a lower growth investment. Both scenarios would explain why TSRI has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing TSRI to are fairly valued by the market. If this assumption is violated, TSRI'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? 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 TSRI 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 TSRI 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.
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 TSR 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.