Telit Communications PLC (AIM:TCM) is currently trading at a trailing P/E of 37.2x, which is higher than the industry average of 14.9x. While this makes TCM 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 break down what the P/E ratio is, how to interpret it and what to watch out for.

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.

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as TCM, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 37.2x, TCM’s P/E is higher than its industry peers (14.9x). This implies that investors are overvaluing each dollar of TCM’s earnings. As such, our analysis shows that TCM represents an over-priced stock.

A few caveats
While our conclusion might prompt you to sell your TCM shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to TCM. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with TCM, then TCM’s P/E would naturally be higher since investors would reward TCM’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with TCM, TCM’s P/E would again be higher since investors would reward TCM’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing TCM to are fairly valued by the market. If this assumption is violated, TCM’s P/E may be higher than its peers because its peers are actually undervalued 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 TCM. 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 highly recommend you to complete your research by taking a look at the following:

1. Financial Health: Is TCM’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.
2. Past Track Record: Has TCM 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 TCM’s historicals for more clarity.
3. 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.