TransAct Technologies Incorporated (NASDAQ:TACT) is trading with a trailing P/E of 29.7x, which is higher than the industry average of 18.7x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, 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 TransAct Technologies
Demystifying 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 TACT
Price-Earnings Ratio = Price per share ÷ Earnings per share
TACT Price-Earnings Ratio = $12.85 ÷ $0.433 = 29.7x
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 TACT, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since TACT’s P/E of 29.7x is higher than its industry peers (18.7x), it means that investors are paying more than they should for each dollar of TACT’s earnings. Therefore, according to this analysis, TACT is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that TACT should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to TACT, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with TACT, 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 TACT to are fairly valued by the market. If this does not hold, there is a possibility that TACT’s P/E is lower because our peer group is overvalued by the market.
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.