Calpine Corporation (NYSE:CPN) is trading with a trailing P/E of 112.7x, which is higher than the industry average of 41x. While CPN 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for CPN

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 CPN

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

CPN Price-Earnings Ratio = 14.94 ÷ 0.133 = 112.7x

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 CPN, 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. At 112.7x, CPN’s P/E is higher than its industry peers (41x). This implies that investors are overvaluing each dollar of CPN’s earnings. Therefore, according to this analysis, CPN is an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your CPN shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CPN, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with CPN, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing CPN to are fairly valued by the market. If this does not hold, there is a possibility that CPN’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 rebalance your portfolio and reduce your holdings in CPN. 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 you are considering investing in CPN, 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.

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 Calpine 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.