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At $12.78, Is It Time To Buy ZCL Composites Inc (TSX:ZCL)?

ZCL Composites Inc (TSX:ZCL) is trading with a trailing P/E of 19.2x, which is lower than the industry average of 57.8x. While this makes ZCL appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 ZCL Composites

Demystifying the P/E ratio

TSX:ZCL PE PEG Gauge Sep 29th 17
TSX:ZCL PE PEG Gauge Sep 29th 17

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.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for ZCL

Price per share = 12.78

Earnings per share = 0.664

∴ Price-Earnings Ratio = 12.78 ÷ 0.664 = 19.2x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ZCL, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.

ZCL’s P/E of 19.2x is lower than its industry peers (57.8x), which implies that each dollar of ZCL’s earnings is being undervalued by investors. As such, our analysis shows that ZCL represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy ZCL, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to ZCL. 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 lower risk firms with ZCL, then ZCL’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with ZCL. In this case, ZCL’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ZCL to are fairly valued by the market. If this assumption is violated, ZCL's P/E may be lower than its peers because its peers are actually overvalued by investors.

TSX:ZCL Future Profit Sep 29th 17
TSX:ZCL Future Profit Sep 29th 17

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on ZCL, the undervaluation of the stock may mean it is a good time to top up on 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.

Are you a potential investor? If you are considering investing in ZCL, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.

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 ZCL Composites 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.

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