Class Limited (ASX:CL1) is currently trading at a trailing P/E of 41.5x, which is higher than the industry average of 33.7x. While this makes CL1 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Class
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief 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 CL1
Price-Earnings Ratio = Price per share ÷ Earnings per share
CL1 Price-Earnings Ratio = 2.83 ÷ 0.068 = 41.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CL1, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. CL1’s P/E of 41.5x is higher than its industry peers (33.7x), which implies that each dollar of CL1’s earnings is being overvalued by investors. Therefore, according to this analysis, CL1 is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your CL1 shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to CL1, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with CL1, 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 CL1 to are fairly valued by the market. If this does not hold, there is a possibility that CL1’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on CL1, the overvaluation of the stock may mean it is a good time to reduce 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 you are considering investing in CL1, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.