Goodyear Tire & Rubber Co (NASDAQ: GT), a consumer discretionary company with a market capitalization of $6.2 billion, currently trades at a P/E multiple of 18.0x which is below the sector’s median multiple of 19.6x. Although this makes GT look attractive, investors may change their mind after reviewing the assumptions behind the P/E ratio. In the post below, I explain how to apply P/E multiples and what to watch out for.
How To Utilize Goodyear Tire & Rubber’s PE Multiples
A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against companies deemed to be similar. We can then determine if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare Goodyear Tire & Rubber’s P/E ratio to its peer group that includes Delphi Automotive plc (NYSE: APTV), Cooper Tire & Rubber Company (NYSE: CTB), Bridgestone Corp. (NYSE: BRDCY) and Bridgestone Corp. (NYSE: BRDCF).
Since Goodyear Tire & Rubber’s P/E ratio of 18.0x is higher than the median of its peers (11.7x), it means that investors are paying more than they should for each dollar of GT’s earnings. As such, our analysis shows that GT represents an overvalued stock. Furthermore, finbox.io’s P/E Ratio Model calculates a fair value of approximately $16.50 per share which implies roughly 35.0% downside.
I selected a fair multiple of 11.7x in my analysis by averaging Goodyear Tire & Rubber’s current P/E ratio with its peer group.
The P/E Ratio’s Flaws
While this approach typically provides a reasonable valuation range, it is important to understand that our conclusion rests on some important assumptions. The first being that the selected peer group actually contains companies that truly are similar to Goodyear Tire & Rubber. The second important assumption is that the selected peer group stocks are being fairly valued by the market.
If the assumptions above do not hold to be true, then the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare Goodyear Tire & Rubber with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
On the other hand, if the second assumption does not hold true, Goodyear Tire & Rubber’s higher multiple may be because our selected comparable companies are being undervalued by the market.
What To Do Next
As a current investor, you may have already conducted fundamental analysis on the company and its stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to GT. But keep in mind the P/E ratio’s potential flaws when applying this valuation approach. It is important to note that there are a variety of other fundamental factors that I have not taken into consideration in this article. I highly recommend that you continue your research on Goodyear Tire & Rubber by taking a look at the following:
Valuation Metrics: how much upside do shares of Goodyear Tire & Rubber have based on Wall Street’s consensus price target? Take a look at our analyst upside data explorer that compares the company’s upside relative to its peers.
Risk Metrics: how is Goodyear Tire & Rubber’s financial health? Find out by viewing our financial leverage data metric which plots the dollars in total assets for each dollar of common equity over time.
Efficiency Metrics: is management becoming more or less efficient over time? Find out by analyzing the company’s asset turnover ratio which measures the dollars in revenue a company generates per dollar of assets.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.