CSL Limited (ASX:CSL) is trading with a trailing P/E of 36.4x, which is higher than the industry average of 23.5x. While CSL 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for CSL
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 CSL
Price-Earnings Ratio = Price per share ÷ Earnings per share
CSL Price-Earnings Ratio = $107.02 ÷ $2.937 = 36.4x
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 CSL, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. CSL’s P/E of 36.4x is higher than its industry peers (23.5x), which implies that each dollar of CSL’s earnings is being overvalued by investors. Therefore, according to this analysis, CSL is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CSL 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 CSL. 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 CSL, 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 CSL to are fairly valued by the market. If this is violated, CSL’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? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to CSL. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in CSL, 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.