Cinemark Holdings Inc (NYSE:CNK) trades with a trailing P/E of 15.5x, which is lower than the industry average of 27.5x. While CNK might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for CNK

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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.

Formula

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

P/E Calculation for CNK

Price per share = 36.41

Earnings per share = 2.355

∴ Price-Earnings Ratio = 36.41 ÷ 2.355 = 15.5x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CNK, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 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 15.5x, CNK’s P/E is lower than its industry peers (27.5x). This implies that investors are undervaluing each dollar of CNK’s earnings. As such, our analysis shows that CNK represents an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy CNK, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to CNK. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with CNK, then CNK’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with CNK, CNK’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing CNK to are fairly valued by the market. If this assumption is violated, CNK's P/E may be lower than its peers because its peers are actually overvalued by investors.