Ceapro Inc (TSXV:CZO) is currently trading at a trailing P/E of 36.4x, which is higher than the industry average of 26.1x. While this makes CZO 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. 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. Check out our latest analysis for Ceapro
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CZO
Price per share = 0.57
Earnings per share = 0.016
∴ Price-Earnings Ratio = 0.57 ÷ 0.016 = 36.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CZO, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
CZO’s P/E of 36.4x is higher than its industry peers (26.1x), which implies that each dollar of CZO’s earnings is being overvalued by investors. Therefore, according to this analysis, CZO is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your CZO shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CZO. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with CZO, then investors would naturally value CZO at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with CZO, investors would also value CZO at a higher price since it is a higher growth investment. Both scenarios would explain why CZO has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CZO to are fairly valued by the market. If this assumption is violated, CZO’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to CZO. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in CZO, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Ceapro for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.