Should You Be Tempted To Sell ChemoCentryx Inc (NASDAQ:CCXI) Because Of Its PE Ratio?

ChemoCentryx Inc (NASDAQ:CCXI) trades with a trailing P/E of 39.4x, which is higher than the industry average of 27.6x. 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. See our latest analysis for ChemoCentryx

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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.

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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CCXI, such as size and country of operation. 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 CCXI's P/E of 39.4x is higher than its industry peers (27.6x), it means that investors are paying more than they should for each dollar of CCXI's earnings. As such, our analysis shows that CCXI represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your CCXI shares 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 CCXI. 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 CCXI, then CCXI’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 CCXI. In this case, CCXI’s P/E would be higher since investors would also reward CCXI’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CCXI to are fairly valued by the market. If this does not hold, there is a possibility that CCXI’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 CCXI, 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 CCXI’s future growth? Take a look at our free research report of analyst consensus for CCXI’s outlook.
2. Past Track Record: Has CCXI 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 CCXI'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.