Tornos Holding AG (SWX:TOHN) is trading with a trailing P/E of 35.5x, which is higher than the industry average of 25.8x. While this makes TOHN appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. 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. View our latest analysis for Tornos Holding
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 TOHN
Price-Earnings Ratio = Price per share ÷ Earnings per share
TOHN Price-Earnings Ratio = CHF15.8 ÷ CHF0.446 = 35.5x
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 TOHN, 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. TOHN’s P/E of 35.5x is higher than its industry peers (25.8x), which implies that each dollar of TOHN’s earnings is being overvalued by investors. As such, our analysis shows that TOHN represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your TOHN 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 TOHN. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with TOHN, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing TOHN to are fairly valued by the market. If this is violated, TOHN’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
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 TOHN. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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: