Custodian REIT Plc (LSE:CREI) is trading with a trailing P/E of 14.4x, which is higher than the industry average of 13.8x. 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. 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 Custodian REIT
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CREI
Price per share = £1.17
Earnings per share = £0.081
∴ Price-Earnings Ratio = £1.17 ÷ £0.081 = 14.4x
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 CREI, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 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.
Since CREI’s P/E of 14.4x is higher than its industry peers (13.8x), it means that investors are paying more than they should for each dollar of CREI’s earnings. Therefore, according to this analysis, CREI is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your CREI shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CREI. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with CREI, then CREI’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 CREI. In this case, CREI’s P/E would be higher since investors would also reward CREI’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CREI to are fairly valued by the market. If this assumption is violated, CREI’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you: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 CREI. 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. 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:
1. Financial Health: Is CREI’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
2. Valuation: What is CREI worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether CREI is currently mispriced by the market.
3. 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.