Is The Clorox Company's (NYSE:CLX) PE Ratio A Signal To Sell For Investors?

The Clorox Company (NYSE:CLX) is currently trading at a trailing P/E of 25.5x, which is higher than the industry average of 25.1x. While this makes CLX 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Clorox

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.

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 CLX, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 25.5x, CLX’s P/E is higher than its industry peers (25.1x). This implies that investors are overvaluing each dollar of CLX’s earnings. As such, our analysis shows that CLX represents an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that CLX should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to CLX. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with CLX, then investors would naturally value CLX at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with CLX, investors would also value CLX at a higher price since it is a higher growth investment. Both scenarios would explain why CLX has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CLX to are fairly valued by the market. If this assumption is violated, CLX's P/E may be higher than its peers because its peers are actually undervalued by investors.

What this means for you:

Since you may have already conducted your due diligence on CLX, 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 urge you to complete your research by taking a look at the following:

• 1. Future Outlook: What are well-informed industry analysts predicting for CLX’s future growth? Take a look at our free research report of analyst consensus for CLX’s outlook.
• 2. Past Track Record: Has CLX 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 CLX'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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.