Centuria Metropolitan REIT (ASX:CMA) is currently trading at a trailing P/E of 10.6x, which is higher than the industry average of 7.2x. While this makes CMA 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Centuria Metropolitan REIT
What you need to know about 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 dollar of the company’s earnings.
P/E Calculation for CMA
Price-Earnings Ratio = Price per share ÷ Earnings per share
CMA Price-Earnings Ratio = 2.41 ÷ 0.228 = 10.6x
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 CMA, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 10.6x, CMA’s P/E is higher than its industry peers (7.2x). This implies that investors are overvaluing each dollar of CMA’s earnings. Therefore, according to this analysis, CMA is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CMA should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to CMA, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with CMA, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing CMA to are fairly valued by the market. If this does not hold, there is a possibility that CMA’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on CMA, the overvaluation of the stock may mean it is a good time to reduce 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.
Are you a potential investor? If CMA has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.