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Cochlear Limited (ASX:COH) trades with a trailing P/E of 51.3x, which is higher than the industry average of 43.5x. While this makes COH appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Cochlear
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 COH
Price-Earnings Ratio = Price per share ÷ Earnings per share
COH Price-Earnings Ratio = A$198.93 ÷ A$3.881 = 51.3x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as COH, 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 COH’s P/E of 51.3x is higher than its industry peers (43.5x), it means that investors are paying more than they should for each dollar of COH’s earnings. As such, our analysis shows that COH represents an over-priced stock.
A few caveats
Before you jump to the conclusion that COH should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to COH, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with COH, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing COH to are fairly valued by the market. If this is violated, COH’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on COH, 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: