This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Century Aluminum Company (NASDAQ:CENX) trades with a trailing P/E of 14.9x, which is higher than the industry average of 10.7x. While this makes CENX appear like a stock to avoid or sell if you own it, 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.
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 CENX
Price-Earnings Ratio = Price per share ÷ Earnings per share
CENX Price-Earnings Ratio = $11.95 ÷ $0.804 = 14.9x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CENX, 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. CENX’s P/E of 14.9x is higher than its industry peers (10.7x), which implies that each dollar of CENX’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Metals and Mining companies in US including North American Potash Developments, European Electric Metals and Sherritt International. As such, our analysis shows that CENX represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your CENX shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to CENX. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with CENX, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing CENX to are fairly valued by the market. If this does not hold true, CENX’s lower P/E ratio may be because firms in our peer group are 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 overvaluation could signal a potential selling opportunity to reduce your exposure to CENX. 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 CENX’s future growth? Take a look at our free research report of analyst consensus for CENX’s outlook.
- Past Track Record: Has CENX 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 CENX’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 firstname.lastname@example.org.