GTN Limited (ASX:GTN) is trading with a trailing P/E of 92.3x, which is higher than the industry average of 18x. 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 GTN
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 GTN
Price-Earnings Ratio = Price per share ÷ Earnings per share
GTN Price-Earnings Ratio = A$2.68 ÷ A$0.029 = 92.3x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GTN, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since GTN’s P/E of 92.3x is higher than its industry peers (18x), it means that investors are paying more than they should for each dollar of GTN’s earnings. As such, our analysis shows that GTN represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your GTN shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GTN. 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 GTN, 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 GTN to are fairly valued by the market. If this does not hold true, GTN’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 GTN, 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.