Centrica plc (LSE:CNA) trades with a trailing P/E of 16.7x, which is lower than the industry average of 18.2x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for CNA
Demystifying 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 pound of the company’s earnings.
P/E Calculation for CNA
Price-Earnings Ratio = Price per share ÷ Earnings per share
CNA Price-Earnings Ratio = 1.73 ÷ 0.104 = 16.7x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CNA, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since CNA's P/E of 16.7x is lower than its industry peers (18.2x), it means that investors are paying less than they should for each dollar of CNA's earnings. As such, our analysis shows that CNA represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy CNA immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CNA, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CNA, 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 CNA to are fairly valued by the market. If this does not hold true, CNA’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? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of CNA to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in CNA, 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.