This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Fortis Inc (TSE:FTS) is currently trading at a trailing P/E of 18.3x, which is lower than the industry average of 21.4x. 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. In this article, 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 Fortis
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 FTS
Price-Earnings Ratio = Price per share ÷ Earnings per share
FTS Price-Earnings Ratio = CA$42.28 ÷ CA$2.315 = 18.3x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to FTS, 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 FTS’s P/E of 18.3 is lower than its industry peers (21.4), it means that investors are paying less for each dollar of FTS’s earnings. Since the Electric Utilities sector in CA 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 Crius Energy Trust, Hydro One and Emera. You can think of it like this: the market is suggesting that FTS is a weaker business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to FTS, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with FTS, 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 FTS to are fairly valued by the market. If this does not hold, there is a possibility that FTS’s P/E is lower because our peer group is overvalued by the market.