CVS Health Corporation (NYSE:CVS) is currently trading at a trailing P/E of 16x, which is lower than the industry average of 20.4x. While CVS 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 CVS
Breaking down the Price-Earnings 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 CVS
Price-Earnings Ratio = Price per share ÷ Earnings per share
CVS Price-Earnings Ratio = 80.9 ÷ 5.056 = 16x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CVS, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since CVS's P/E of 16x is lower than its industry peers (20.4x), it means that investors are paying less than they should for each dollar of CVS's earnings. As such, our analysis shows that CVS represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CVS is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to CVS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with CVS, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing CVS to are fairly valued by the market. If this does not hold true, CVS’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? Since you may have already conducted your due diligence on CVS, the undervaluation of the stock may mean it is a good time to top up on 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 CVS, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.