This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
China Biologic Products Holdings Inc (NASDAQ:CBPO) trades with a trailing P/E of 45.5x, which is higher than the industry average of 26.6x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CBPO
Price per share = $97.45
Earnings per share = $2.14
∴ Price-Earnings Ratio = $97.45 ÷ $2.14 = 45.5x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CBPO, such as company lifetime and products sold. 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.
At 45.5x, CBPO’s P/E is higher than its industry peers (26.6x). This implies that investors are overvaluing each dollar of CBPO’s earnings. This multiple is a median of profitable companies of 25 Biotechs companies in US including HEALTHeUNIVERSE, Forward Pharma and Portage Biotech. Therefore, according to this analysis, CBPO is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your CBPO shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to CBPO. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with CBPO, then CBPO’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with CBPO. In this case, CBPO’s P/E would be higher since investors would also reward CBPO’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CBPO to are fairly valued by the market. If this assumption does not hold true, CBPO’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in CBPO. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for CBPO’s future growth? Take a look at our free research report of analyst consensus for CBPO’s outlook.
- Past Track Record: Has CBPO been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of CBPO’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.