Contact Energy Limited (NZSE:CEN) trades with a trailing P/E of 26.5x, which is higher than the industry average of 24.9x. While CEN 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. 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. View our latest analysis for Contact Energy
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 CEN
Price-Earnings Ratio = Price per share ÷ Earnings per share
CEN Price-Earnings Ratio = NZ$5.56 ÷ NZ$0.21 = 26.5x
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 CEN, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. CEN’s P/E of 26.5x is higher than its industry peers (24.9x), which implies that each dollar of CEN’s earnings is being overvalued by investors. As such, our analysis shows that CEN represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CEN should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to CEN. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with CEN, 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 CEN to are fairly valued by the market. If this is violated, CEN’s P/E may be lower than its peers as they are actually overvalued by investors.
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 CEN. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.