I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Otelco Inc (NASDAQ:OTEL) trades with a trailing P/E of 4x, which is lower than the industry average of 15.1x. While this makes OTEL 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.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 OTEL
Price-Earnings Ratio = Price per share ÷ Earnings per share
OTEL Price-Earnings Ratio = $16.5 ÷ $4.12 = 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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as OTEL, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. OTEL’s P/E of 4 is lower than its industry peers (15.1), which implies that each dollar of OTEL’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 21 Telecom companies in US including 727 Communications, Glowpoint and Globalstar. You can think of it like this: the market is suggesting that OTEL is a weaker business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to OTEL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with OTEL, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing OTEL to are fairly valued by the market. If this does not hold, there is a possibility that OTEL’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to OTEL. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 urge you to complete your research by taking a look at the following:
- Financial Health: Are OTEL’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has OTEL 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 OTEL’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 firstname.lastname@example.org.