Tesco PLC (LSE:TSCO) trades with a trailing P/E of 36.8x, which is higher than the industry average of 25x. While TSCO might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Tesco
Breaking down the Price-Earnings 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 pound of the company’s earnings.
P/E Calculation for TSCO
Price-Earnings Ratio = Price per share ÷ Earnings per share
TSCO Price-Earnings Ratio = £2.07 ÷ £0.056 = 36.8x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to TSCO, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 36.8x, TSCO’s P/E is higher than its industry peers (25x). This implies that investors are overvaluing each dollar of TSCO’s earnings. Therefore, according to this analysis, TSCO is an over-priced stock.
A few caveats
However, before you rush out to sell your TSCO shares, 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 TSCO, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with TSCO, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing TSCO to are fairly valued by the market. If this does not hold true, TSCO’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 rebalance your portfolio and reduce your holdings in TSCO. 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 TSCO 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.