CTS Corporation (NYSE:CTS) trades with a trailing P/E of 26.3x, which is lower than the industry average of 27x. 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. 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. See our latest analysis for CTS

What you need to know about the P/E ratio

P/E is a popular ratio used for 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.

Formula

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

P/E Calculation for CTS

Price per share = 24.4

Earnings per share = 0.929

∴ Price-Earnings Ratio = 24.4 ÷ 0.929 = 26.3x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CTS, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.

Since CTS's P/E of 26.3x is lower than its industry peers (27x), it means that investors are paying less than they should for each dollar of CTS's earnings. As such, our analysis shows that CTS represents an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that CTS represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to CTS. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with CTS, then CTS’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with CTS. In this case, CTS’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CTS to are fairly valued by the market. If this assumption is violated, CTS's P/E may be lower than its peers because its peers are actually overvalued by investors.