Costa Group Holdings Limited (ASX:CGC) trades with a trailing P/E of 31.8x, which is higher than the industry average of 10.5x. While CGC might seem like a stock to avoid or sell if you own it, 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. View our latest analysis for Costa Group Holdings
Demystifying 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 CGC
Price-Earnings Ratio = Price per share ÷ Earnings per share
CGC Price-Earnings Ratio = A$5.75 ÷ A$0.181 = 31.8x
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 CGC, 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. CGC’s P/E of 31.8x is higher than its industry peers (10.5x), which implies that each dollar of CGC’s earnings is being overpriced by investors. Therefore, according to this analysis, CGC is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CGC 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 CGC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CGC, 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 CGC to are fairly valued by the market. If this does not hold true, CGC’s lower P/E ratio may be because firms in our peer group are 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.