This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
TK Development A/S (CPH:TKDV) trades with a trailing P/E of 26.1x, which is higher than the industry average of 8.9x. 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.
Breaking down the P/E ratio
P/E is a popular ratio used for 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 TKDV
Price-Earnings Ratio = Price per share ÷ Earnings per share
TKDV Price-Earnings Ratio = DKK6.63 ÷ DKK0.254 = 26.1x
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 TKDV, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since TKDV’s P/E of 26.1x is higher than its industry peers (9.1x), it means that investors are paying more than they should for each dollar of TKDV’s earnings. Since the Real Estate sector in DK is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Park Street Nordicom, German High Street Properties and Jeudan. As such, our analysis shows that TKDV represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that TKDV 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 TKDV. 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 TKDV, 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 TKDV to are fairly valued by the market. If this does not hold true, TKDV’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on TKDV, 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. 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 TKDV’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 TKDV 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 TKDV’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.