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Exelon Corporation (NYSE:EXC) is currently trading at a trailing P/E of 9.7x, which is lower than the industry average of 14.2x. While this makes EXC appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Exelon
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. 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 EXC
Price-Earnings Ratio = Price per share ÷ Earnings per share
EXC Price-Earnings Ratio = $38.75 ÷ $3.981 = 9.7x
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 EXC, 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. At 9.7x, EXC’s P/E is lower than its industry peers (14.2x). This implies that investors are undervaluing each dollar of EXC’s earnings. As such, our analysis shows that EXC represents an under-priced stock.
A few caveats
Before you jump to the conclusion that EXC 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 EXC, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with EXC, 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 EXC to are fairly valued by the market. If this does not hold, there is a possibility that EXC’s P/E is lower because our peer group is overvalued by the market.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.