Central Securities Corp (AMEX:CET) is trading with a trailing P/E of 3.8x, which is lower than the industry average of 20.2x. While CET might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for CET
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CET
Price per share = 24.8
Earnings per share = 6.574
∴ Price-Earnings Ratio = 24.8 ÷ 6.574 = 3.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CET, 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 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 CET's P/E of 3.8x is lower than its industry peers (20.2x), it means that investors are paying less than they should for each dollar of CET's earnings. Therefore, according to this analysis, CET is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy CET 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 CET. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with CET, then investors would naturally value CET at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with CET, investors would also value CET at a lower price since it is a lower growth investment. Both scenarios would explain why CET has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CET to are fairly valued by the market. If this assumption does not hold true, CET’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
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 CET 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 CET has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
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 Central Securities 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.