Should You Sell TransCanada Corporation (TSX:TRP) At $61.65?
TransCanada Corporation (TSX:TRP) is trading with a trailing P/E of 50.3x, which is higher than the industry average of 22.1x. While this makes TRP appear like a stock to avoid or sell if you own it, 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. See our latest analysis for TRP
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 TRP
Price-Earnings Ratio = Price per share ÷ Earnings per share
TRP Price-Earnings Ratio = 61.65 ÷ 1.225 = 50.3x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to TRP, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. TRP’s P/E of 50.3x is higher than its industry peers (22.1x), which implies that each dollar of TRP’s earnings is being overvalued by investors. Therefore, according to this analysis, TRP is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that TRP should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to TRP. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with TRP, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing TRP to are fairly valued by the market. If this does not hold true, TRP’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on TRP, 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.
Are you a potential investor? If you are considering investing in TRP, 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 TransCanada 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.
