Cellnet Group Limited (ASX:CLT) trades with a trailing P/E of 7.2x, which is lower than the industry average of 17.3x. While CLT might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Cellnet Group
What you need to know about the P/E ratio
P/E is a popular ratio used for 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 CLT
Price per share = A$0.37
Earnings per share = A$0.052
∴ Price-Earnings Ratio = A$0.37 ÷ A$0.052 = 7.2x
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 CLT, 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. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 7.2x, CLT’s P/E is lower than its industry peers (17.3x). This implies that investors are undervaluing each dollar of CLT’s earnings. As such, our analysis shows that CLT represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy CLT immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CLT. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with CLT, then investors would naturally value CLT at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with CLT, investors would also value CLT at a lower price since it is a lower growth investment. Both scenarios would explain why CLT has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CLT to are fairly valued by the market. If this does not hold, there is a possibility that CLT’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on CLT, the undervaluation of the stock may mean it is a good time to top up on 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. 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Is CLT’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.
- Past Track Record: Has CLT 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 CLT’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.