I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Connexion Media Limited (ASX:CXZ) is currently trading at a trailing P/E of 10x, which is lower than the industry average of 31.9x. While this makes CXZ appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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.
P/E Calculation for CXZ
Price-Earnings Ratio = Price per share ÷ Earnings per share
CXZ Price-Earnings Ratio = A$0.0070 ÷ A$0.000700 = 10x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CXZ, 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. At 10, CXZ’s P/E is lower than its industry peers (31.9). This implies that investors are undervaluing each dollar of CXZ’s earnings. This multiple is a median of profitable companies of 19 Software companies in AU including DigitalX, Adacel Technologies and JCurve Solutions. You can think of it like this: the market is suggesting that CXZ is a weaker business than the average comparable company.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to CXZ, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CXZ, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CXZ to are fairly valued by the market. If this does not hold, there is a possibility that CXZ’s P/E is lower because our peer group is 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 CXZ. 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: Are CXZ’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.
- 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 firstname.lastname@example.org.