Classic Minerals Limited (ASX:CLZ) trades with a trailing P/E of 1.7x, which is lower than the industry average of 11.1x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Classic Minerals
Breaking down the Price-Earnings 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.
P/E Calculation for CLZ
Price-Earnings Ratio = Price per share ÷ Earnings per share
CLZ Price-Earnings Ratio = 0.01 ÷ 0.004 = 1.7x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CLZ, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. CLZ’s P/E of 1.7x is lower than its industry peers (11.1x), which implies that each dollar of CLZ’s earnings is being undervalued by investors. As such, our analysis shows that CLZ represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy CLZ immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to CLZ. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with CLZ, 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 CLZ to are fairly valued by the market. If this is violated, CLZ's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of CLZ to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in CLZ, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Classic Minerals for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass 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.