Canadian National Railway Company (NYSE:CNI) is currently trading at a trailing P/E of 19.7x, which is lower than the industry average of 28.2x. While this makes CNI appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Canadian National Railway
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 CNI
Price-Earnings Ratio = Price per share ÷ Earnings per share
CNI Price-Earnings Ratio = CA$101.09 ÷ CA$5.128 = 19.7x
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 CNI, 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. CNI’s P/E of 19.7x is lower than its industry peers (28.2x), which implies that each dollar of CNI’s earnings is being undervalued by investors. As such, our analysis shows that CNI represents an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy CNI, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to CNI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with CNI, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing CNI to are fairly valued by the market. If this does not hold, there is a possibility that CNI’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 CNI, 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 CNI 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.