The Citadel Group Limited (ASX:CGL) trades with a trailing P/E of 23.1x, which is lower than the industry average of 23.3x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Citadel Group
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 CGL
Price-Earnings Ratio = Price per share ÷ Earnings per share
CGL Price-Earnings Ratio = 5.56 ÷ 0.24 = 23.1x
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 CGL, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. CGL’s P/E of 23.1x is lower than its industry peers (23.3x), which implies that each dollar of CGL’s earnings is being undervalued by investors. As such, our analysis shows that CGL represents an under-priced stock.
A few caveats
Before you jump to the conclusion that CGL is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to CGL, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CGL, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing CGL to are fairly valued by the market. If this does not hold true, CGL’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of CGL to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in CGL, 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.