The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to better understand how you can grow your money by investing in Compass Minerals International Inc (NYSE:CMP).
Compass Minerals International Inc (NYSE:CMP) is currently trading at a trailing P/E of 70.4x, which is higher than the industry average of 12.9x. 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View out our latest analysis for Compass Minerals International
Demystifying 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 CMP
Price per share = $69.3
Earnings per share = $0.984
∴ Price-Earnings Ratio = $69.3 ÷ $0.984 = 70.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CMP, such as size and country of operation. 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.
CMP’s P/E of 70.4x is higher than its industry peers (12.9x), which implies that each dollar of CMP’s earnings is being overvalued by investors. Therefore, according to this analysis, CMP is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your CMP shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CMP. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with CMP, then CMP’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 CMP. In this case, CMP’s P/E would be higher since investors would also reward CMP’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CMP to are fairly valued by the market. If this does not hold, there is a possibility that CMP’s P/E is higher 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 CMP, 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:
- Future Outlook: What are well-informed industry analysts predicting for CMP’s future growth? Take a look at our free research report of analyst consensus for CMP’s outlook.
- Past Track Record: Has CMP 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 CMP’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.