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Does Toromont Industries Ltd’s (TSE:TIH) PE Ratio Warrant A Sell?

Toromont Industries Ltd (TSE:TIH) trades with a trailing P/E of 25.4, which is higher than the industry average of 14. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.

Breaking down the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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.

P/E Calculation for TIH

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

TIH Price-Earnings Ratio = CA\$65.35 ÷ CA\$2.573 = 25.4x

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 TIH, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. TIH’s P/E of 25.4 is higher than its industry peers (14), which implies that each dollar of TIH’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 11 Trade Distributors companies in CA including Rocky Mountain Dealerships, Cervus Equipment and Russel Metals. You could think of it like this: the market is pricing TIH as if it is a stronger company than the average of its industry group.

Assumptions to watch out for

However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to TIH. If this isn’t the case, the difference in P/E could be due to other factors. For example, Toromont Industries Ltd could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to TIH may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.

What this means for you:

Since you may have already conducted your due diligence on TIH, 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for TIH’s future growth? Take a look at our free research report of analyst consensus for TIH’s outlook.
2. Past Track Record: Has TIH been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of TIH’s historicals for more clarity.
3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.