CVC Limited (ASX:CVC) is currently trading at a trailing P/E of 12.5x, which is lower than the industry average of 20x. While CVC might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for CVC

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 CVC

Price-Earnings Ratio = Price per share ÷ Earnings per share

CVC Price-Earnings Ratio = A$2.83 ÷ A$0.226 = 12.5x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CVC, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 12.5x, CVC’s P/E is lower than its industry peers (20x). This implies that investors are undervaluing each dollar of CVC’s earnings. Therefore, according to this analysis, CVC is an under-priced stock.

A few caveats

While our conclusion might prompt you to buy CVC immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CVC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CVC, 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 CVC to are fairly valued by the market. If this is violated, CVC’s P/E may be lower than its peers as they are actually overvalued by investors.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.