Codan Limited (ASX:CDA) is trading with a trailing P/E of 9.9x, which is lower than the industry average of 26.1x. While CDA 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 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 Codan
Breaking down the P/E 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 CDA
Price-Earnings Ratio = Price per share ÷ Earnings per share
CDA Price-Earnings Ratio = 2.42 ÷ 0.246 = 9.9x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 CDA, 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 9.9x, CDA’s P/E is lower than its industry peers (26.1x). This implies that investors are undervaluing each dollar of CDA’s earnings. As such, our analysis shows that CDA represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy CDA immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CDA, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CDA, 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 CDA to are fairly valued by the market. If this does not hold true, CDA’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on CDA, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If CDA 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.