Global Cord Blood Corporation (NYSE:CO) is trading with a trailing P/E of 25.4x, which is higher than the industry average of 20.4x. While this makes CO appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Global Cord Blood
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 CO
Price per share = CN¥59.68
Earnings per share = CN¥2.354
∴ Price-Earnings Ratio = CN¥59.68 ÷ CN¥2.354 = 25.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 CO, 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.
CO’s P/E of 25.4x is higher than its industry peers (20.4x), which implies that each dollar of CO’s earnings is being overvalued by investors. As such, our analysis shows that CO represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CO should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to CO. 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 CO, then investors would naturally value CO at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with CO, investors would also value CO at a higher price since it is a higher growth investment. Both scenarios would explain why CO has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CO to are fairly valued by the market. If this does not hold, there is a possibility that CO’s P/E is higher because firms in our peer group are being undervalued 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 rebalance your portfolio and reduce your holdings in CO. 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 CO’s future growth? Take a look at our free research report of analyst consensus for CO’s outlook.
- Past Track Record: Has CO 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 CO’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.