I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Finning International Inc (TSE:FTT) is currently trading at a trailing P/E of 18.3, which is higher than the industry average of 12.3. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 FTT
Price-Earnings Ratio = Price per share ÷ Earnings per share
FTT Price-Earnings Ratio = CA$29.48 ÷ CA$1.611 = 18.3x
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 FTT, 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. FTT’s P/E of 18.3 is higher than its industry peers (12.3), which implies that each dollar of FTT’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 Hardwoods Distribution. You could also say that the market is suggesting that FTT is a stronger business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to FTT. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Finning International Inc is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with FTT are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in FTT. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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:
- Future Outlook: What are well-informed industry analysts predicting for FTT’s future growth? Take a look at our free research report of analyst consensus for FTT’s outlook.
- Past Track Record: Has FTT 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 FTT’s historicals for more clarity.
- 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 email@example.com.