Cryosite Limited (ASX:CTE) trades with a trailing P/E of 30.2x, which is lower than the industry average of 40.2x. While this makes CTE 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 Cryosite
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 CTE
Price-Earnings Ratio = Price per share ÷ Earnings per share
CTE Price-Earnings Ratio = 0.14 ÷ 0.005 = 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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CTE, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since CTE's P/E of 30.2x is lower than its industry peers (40.2x), it means that investors are paying less than they should for each dollar of CTE's earnings. Therefore, according to this analysis, CTE is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy CTE immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CTE, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CTE, 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 CTE to are fairly valued by the market. If this does not hold, there is a possibility that CTE’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of CTE to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If CTE 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.