I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Canadian Imperial Bank of Commerce (TSE:CM) is currently trading at a trailing P/E of 10.1, which is lower than the industry average of 11.1. Although some investors might think this is a real positive, that might change once you understand the assumptions behind the P/E. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 CM
Price per share = CA$115.74
Earnings per share = CA$11.481
∴ Price-Earnings Ratio = CA$115.74 ÷ CA$11.481 = 10.1x
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 CM, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.
CM’s P/E of 10.1 is lower than its industry peers (11.1), which implies that each dollar of CM’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 8 Banks companies in CA including Laurentian Bank of Canada, National Bank of Canada and Bank of Nova Scotia. One could put it like this: the market is pricing CM as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to CM. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with CM, then investors would naturally value CM at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with CM, investors would also value CM at a lower price since it is a lower growth investment. Both scenarios would explain why CM has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CM to are fairly valued by the market. If this assumption is violated, CM’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to CM. 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:
- Future Outlook: What are well-informed industry analysts predicting for CM’s future growth? Take a look at our free research report of analyst consensus for CM’s outlook.
- Past Track Record: Has CM 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 CM’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 firstname.lastname@example.org.