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CSL Limited (ASX:CSL) trades with a trailing P/E of 36x, which is higher than the industry average of 26.6x. While this makes CSL 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 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 CSL
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 CSL
Price-Earnings Ratio = Price per share ÷ Earnings per share
CSL Price-Earnings Ratio = $128.42 ÷ $3.567 = 36x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 CSL, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 36x, CSL’s P/E is higher than its industry peers (26.6x). This implies that investors are overvaluing each dollar of CSL’s earnings. Therefore, according to this analysis, CSL is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your CSL shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CSL, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CSL, 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 CSL to are fairly valued by the market. If this is violated, CSL’s P/E may be lower than its peers as they are actually overvalued by investors.
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.