Costa Group Holdings Limited (ASX:CGC) is trading with a trailing P/E of 30.2x, which is higher than the industry average of 12.3x. While CGC 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 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 Costa Group Holdings

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 CGC

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

CGC Price-Earnings Ratio = 5.47 ÷ 0.181 = 30.2x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CGC, 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. CGC’s P/E of 30.2x is higher than its industry peers (12.3x), which implies that each dollar of CGC’s earnings is being overvalued by investors. As such, our analysis shows that CGC represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your CGC 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 CGC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CGC, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing CGC to are fairly valued by the market. If this does not hold, there is a possibility that CGC’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on CGC, 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 CGC has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Costa Group Holdings for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.