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Fonterra Co-operative Group Limited (NZSE:FCG) trades with a trailing P/E of 13.2x, which is higher than the industry average of 12.8x. While this makes FCG appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Fonterra Co-operative Group
What you need to know about the P/E ratio
P/E is a popular ratio used for 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 FCG
Price-Earnings Ratio = Price per share ÷ Earnings per share
FCG Price-Earnings Ratio = NZ$6.04 ÷ NZ$0.457 = 13.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FCG, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since FCG’s P/E of 13.2x is higher than its industry peers (12.8x), it means that investors are paying more than they should for each dollar of FCG’s earnings. As such, our analysis shows that FCG represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your FCG shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to FCG, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with FCG, 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 FCG to are fairly valued by the market. If this is violated, FCG’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.