This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Christie Group plc (LON:CTG) trades with a trailing P/E of 8.1, which is lower than the industry average of 18.3. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CTG
Price per share = £1.07
Earnings per share = £0.131
∴ Price-Earnings Ratio = £1.07 ÷ £0.131 = 8.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 CTG, 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 8.1, CTG’s P/E is lower than its industry peers (18.3). This implies that investors are undervaluing each dollar of CTG’s earnings. This multiple is a median of profitable companies of 25 Professional Services companies in GB including Tekcapital, Kellan Group and Mind Gym. You can think of it like this: the market is suggesting that CTG is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CTG. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with CTG, then CTG’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with CTG, CTG’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing CTG to are fairly valued by the market. If this assumption is violated, CTG’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on CTG, 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for CTG’s future growth? Take a look at our free research report of analyst consensus for CTG’s outlook.
- Past Track Record: Has CTG 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 CTG’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.