This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in China Advanced Construction Materials Group Inc (NASDAQ:CADC).
China Advanced Construction Materials Group Inc (NASDAQ:CADC) trades with a trailing P/E of 22.8x, which is higher than the industry average of 17.2x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View out our latest analysis for China Advanced Construction Materials Group
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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CADC
Price per share = $6
Earnings per share = $0.263
∴ Price-Earnings Ratio = $6 ÷ $0.263 = 22.8x
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 CADC, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.
Since CADC’s P/E of 22.8x is higher than its industry peers (17.2x), it means that investors are paying more than they should for each dollar of CADC’s earnings. This multiple is a median of profitable companies of 25 Basic Materials companies in US including China Infrastructure Construction, World Wide Stone and China Runji Cement. Therefore, according to this analysis, CADC is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CADC 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 CADC. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with CADC, then CADC’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with CADC. In this case, CADC’s P/E would be higher since investors would also reward CADC’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CADC to are fairly valued by the market. If this assumption does not hold true, CADC’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on CADC, 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:
- Financial Health: Is CADC’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has CADC 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 CADC’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.