Caleffi Sp.A. (BIT:CLF) is currently trading at a trailing P/E of 60.7x, which is higher than the industry average of 27.9x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Caleffi
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in 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 CLF
Price per share = €1.47
Earnings per share = €0.024
∴ Price-Earnings Ratio = €1.47 ÷ €0.024 = 60.7x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CLF, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
CLF’s P/E of 60.7x is higher than its industry peers (27.9x), which implies that each dollar of CLF’s earnings is being overvalued by investors. Therefore, according to this analysis, CLF is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your CLF shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to CLF. 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 CLF, then CLF’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 CLF. In this case, CLF’s P/E would be higher since investors would also reward CLF’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CLF to are fairly valued by the market. If this does not hold, there is a possibility that CLF’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on CLF, the overvaluation of the stock may mean it is a good time to reduce 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 CLF’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 CLF 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 CLF’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.