CWT Limited (SGX:C14) is trading with a trailing P/E of 12.2x, which is lower than the industry average of 14.1x. 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for CWT

Breaking down the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 C14

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

C14 Price-Earnings Ratio = SGD2.33 ÷ SGD0.191 = 12.2x

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 C14, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 12.2x, C14’s P/E is lower than its industry peers (14.1x). This implies that investors are undervaluing each dollar of C14’s earnings. Therefore, according to this analysis, C14 is an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that C14 is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to C14, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with C14, 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 C14 to are fairly valued by the market. If this does not hold, there is a possibility that C14’s P/E is lower because our peer group is overvalued by the market.

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.