In This Article:
I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Crest Nicholson Holdings plc (LON:CRST) is trading with a trailing P/E of 5.1x, which is lower than the industry average of 11.1x. 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 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 Crest Nicholson Holdings
Demystifying the P/E ratio
P/E is a popular ratio used for 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 CRST
Price-Earnings Ratio = Price per share ÷ Earnings per share
CRST Price-Earnings Ratio = £3.36 ÷ £0.655 = 5.1x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CRST, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 5.1, CRST’s P/E is lower than its industry peers (11.1). This implies that investors are undervaluing each dollar of CRST’s earnings. This multiple is a median of profitable companies of 23 Consumer Durables companies in GB including Walker Greenbank, Berkeley Group Holdings and Redrow. One could put it like this: the market is pricing CRST as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, 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 CRST, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CRST, 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 CRST to are fairly valued by the market. If this is violated, CRST’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on CRST, 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: