Comvita Limited (NZSE:CVT) is trading with a trailing P/E of 34.4x, which is higher than the industry average of 23.6x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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 Comvita
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 CVT
Price-Earnings Ratio = Price per share ÷ Earnings per share
CVT Price-Earnings Ratio = 8.16 ÷ 0.237 = 34.4x
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 CVT, 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. At 34.4x, CVT’s P/E is higher than its industry peers (23.6x). This implies that investors are overvaluing each dollar of CVT’s earnings. Therefore, according to this analysis, CVT is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your CVT shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to CVT. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with CVT, 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 CVT to are fairly valued by the market. If this does not hold true, CVT’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on CVT, 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 CVT 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.