Callaway Golf Company (NYSE:ELY) is trading with a trailing P/E of 7.7x, which is lower than the industry average of 19.3x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Callaway Golf
What you need to know about the P/E 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for ELY
Price per share = $15.04
Earnings per share = $1.947
∴ Price-Earnings Ratio = $15.04 ÷ $1.947 = 7.7x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ELY, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since ELY’s P/E of 7.7x is lower than its industry peers (19.3x), it means that investors are paying less than they should for each dollar of ELY’s earnings. Therefore, according to this analysis, ELY is an under-priced stock.
A few caveats
However, before you rush out to buy ELY, 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 ELY. 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 lower risk firms with ELY, then ELY’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with ELY. In this case, ELY’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ELY to are fairly valued by the market. If this does not hold, there is a possibility that ELY’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 ELY, 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:
- 1. Future Outlook: What are well-informed industry analysts predicting for ELY’s future growth? Take a look at our free research report of analyst consensus for ELY’s outlook.
- 2. Past Track Record: Has ELY 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 ELY’s historicals for more clarity.
- 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.