Should You Be Tempted To Buy Otelco Inc (OTEL) Because Of Its PE Ratio?
Otelco Inc (NASDAQ:OTEL) trades with a trailing P/E of 6.1x, which is lower than the industry average of 19.3x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for OTEL
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 = 9.55 ÷ 1.573 = 6.1x
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 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. At 6.1x, OTEL’s P/E is lower than its industry peers (19.3x). This implies that investors are undervaluing each dollar of OTEL’s earnings. Therefore, according to this analysis, OTEL is an under-priced stock.
A few caveats
However, before you rush out to buy OTEL, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to OTEL, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with OTEL, 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 OTEL to are fairly valued by the market. If this does not hold true, OTEL’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? 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 OTEL 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 OTEL 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 Otelco 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.
