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.
Campbell Soup Company (NYSE:CPB) is currently trading at a trailing P/E of 25.6x, which is higher than the industry average of 19.4x. While CPB might seem like a stock to avoid or sell if you own it, 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.
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 CPB
Price per share = $41.21
Earnings per share = $1.61
∴ Price-Earnings Ratio = $41.21 ÷ $1.61 = 25.6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CPB, such as capital structure and profitability. 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.
At 25.6x, CPB’s P/E is higher than its industry peers (19.4x). This implies that investors are overvaluing each dollar of CPB’s earnings. This multiple is a median of profitable companies of 25 Food companies in US including Kaibo Foods, Keurig Dr Pepper and China Modern Agricultural Information. As such, our analysis shows that CPB represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your CPB shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to CPB. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with CPB, then investors would naturally value CPB at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with CPB, investors would also value CPB at a higher price since it is a higher growth investment. Both scenarios would explain why CPB has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CPB to are fairly valued by the market. If this assumption is violated, CPB’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in CPB. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 CPB’s future growth? Take a look at our free research report of analyst consensus for CPB’s outlook.
- Past Track Record: Has CPB 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 CPB’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.