Caltex Australia Limited (ASX:CTX) is currently trading at a trailing P/E of 15.2x, which is higher than the industry average of 8.1x. While CTX might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Caltex Australia
What you need to know about the P/E 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 CTX
Price-Earnings Ratio = Price per share ÷ Earnings per share
CTX Price-Earnings Ratio = 32.37 ÷ 2.136 = 15.2x
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 CTX, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since CTX's P/E of 15.2x is higher than its industry peers (8.1x), it means that investors are paying more than they should for each dollar of CTX's earnings. Therefore, according to this analysis, CTX is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your CTX shares, 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 CTX, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with CTX, 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 CTX to are fairly valued by the market. If this does not hold true, CTX’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 CTX, the overvaluation of the stock may mean it is a good time to reduce 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 CTX, 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.