China Advanced Construction Materials Group Inc (NASDAQ:CADC) is currently trading at a trailing P/E of 11.9x, which is lower than the industry average of 17.3x. While CADC 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for China Advanced Construction Materials Group
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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 CADC
Price per share = $3.3
Earnings per share = $0.278
∴ Price-Earnings Ratio = $3.3 ÷ $0.278 = 11.9x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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. 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.
Since CADC’s P/E of 11.9x is lower than its industry peers (17.3x), it means that investors are paying less than they should for each dollar of CADC’s earnings. Therefore, according to this analysis, CADC is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy CADC 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 CADC. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with CADC, then investors would naturally value CADC at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with CADC, investors would also value CADC at a lower price since it is a lower growth investment. Both scenarios would explain why CADC has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CADC to are fairly valued by the market. If this does not hold, there is a possibility that CADC’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to CADC. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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.