Textron Inc (NYSE:TXT) is currently trading at a trailing P/E of 25.2x, which is higher than the industry average of 22.9x. While TXT 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. 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 Textron

What you need to know about the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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 TXT

Price-Earnings Ratio = Price per share ÷ Earnings per share

TXT Price-Earnings Ratio = $58.9 ÷ $2.337 = 25.2x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as TXT, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since TXT’s P/E of 25.2x is higher than its industry peers (22.9x), it means that investors are paying more than they should for each dollar of TXT’s earnings. Therefore, according to this analysis, TXT is an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your TXT shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to TXT. 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 TXT, 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 TXT to are fairly valued by the market. If this is violated, TXT’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on TXT, 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.

Are you a potential investor? If you are considering investing in TXT, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Textron for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.