CMI Limited (ASX:CMI) is currently trading at a trailing P/E of 11.5x, which is lower than the industry average of 19x. While CMI 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for CMI

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. 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 CMI

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

CMI Price-Earnings Ratio = A$1.35 ÷ A$0.117 = 11.5x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CMI, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 11.5x, CMI’s P/E is lower than its industry peers (19x). This implies that investors are undervaluing each dollar of CMI’s earnings. Therefore, according to this analysis, CMI is an under-priced stock.

A few caveats

However, before you rush out to buy CMI, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to CMI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with CMI, 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 CMI to are fairly valued by the market. If this is violated, CMI’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.