This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
CalAmp Corp (NASDAQ:CAMP) is currently trading at a trailing P/E of 29.6x, which is higher than the industry average of 27.8x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CAMP
Price per share = $23.27
Earnings per share = $0.786
∴ Price-Earnings Ratio = $23.27 ÷ $0.786 = 29.6x
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 CAMP, 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.
Since CAMP’s P/E of 29.6x is higher than its industry peers (27.8x), it means that investors are paying more than they should for each dollar of CAMP’s earnings. This multiple is a median of profitable companies of 25 Communications companies in US including GuanHua, Inventergy Global and Ciena. As such, our analysis shows that CAMP represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your CAMP shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CAMP. 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 CAMP, then investors would naturally value CAMP at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with CAMP, investors would also value CAMP at a higher price since it is a higher growth investment. Both scenarios would explain why CAMP has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CAMP to are fairly valued by the market. If this assumption does not hold true, CAMP’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to CAMP. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for CAMP’s future growth? Take a look at our free research report of analyst consensus for CAMP’s outlook.
- Past Track Record: Has CAMP 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 CAMP’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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.