This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Constellation Brands Inc (NYSE:STZ) is currently trading at a trailing P/E of 15.3x, which is lower than the industry average of 23.4x. While STZ might seem like an attractive stock to buy, 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 P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 STZ
Price per share = $210.23
Earnings per share = $13.739
∴ Price-Earnings Ratio = $210.23 ÷ $13.739 = 15.3x
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 STZ, 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.
STZ’s P/E of 15.3x is lower than its industry peers (23.4x), which implies that each dollar of STZ’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Beverage companies in US including Rocky Mountain International, Bebida Beverage and RushNet. Therefore, according to this analysis, STZ is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy STZ 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 STZ. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with STZ, then STZ’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 STZ, STZ’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 STZ to are fairly valued by the market. If this does not hold, there is a possibility that STZ’s P/E is lower because firms in our peer group are being overvalued by the market.
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 add more of STZ to your portfolio. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for STZ’s future growth? Take a look at our free research report of analyst consensus for STZ’s outlook.
- Past Track Record: Has STZ 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 STZ’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.