Crown Resorts Limited (ASX:CWN) trades with a trailing P/E of 4.4x, which is lower than the industry average of 21.2x. While CWN 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for CWN
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 CWN
Price-Earnings Ratio = Price per share ÷ Earnings per share
CWN Price-Earnings Ratio = 11.42 ÷ 2.57 = 4.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CWN, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since CWN's P/E of 4.4x is lower than its industry peers (21.2x), it means that investors are paying less than they should for each dollar of CWN's earnings. Therefore, according to this analysis, CWN is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy CWN, 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 CWN, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CWN, 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 CWN to are fairly valued by the market. If this is violated, CWN's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to CWN. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in CWN, 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.