I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
CIMIC Group Limited (ASX:CIM) is currently trading at a trailing P/E of 21.4, which is higher than the industry average of 17.4. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 CIM
Price-Earnings Ratio = Price per share ÷ Earnings per share
CIM Price-Earnings Ratio = A$48.97 ÷ A$2.289 = 21.4x
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 CIM, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 21.4, CIM’s P/E is higher than its industry peers (17.4). This implies that investors are overvaluing each dollar of CIM’s earnings. This multiple is a median of profitable companies of 11 Construction companies in AU including JC International Group, Primero Group and Lycopodium. You could think of it like this: the market is pricing CIM as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to CIM. If this isn’t the case, the difference in P/E could be due to other factors. For example, CIMIC Group Limited could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with CIM are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in CIM. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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:
- Future Outlook: What are well-informed industry analysts predicting for CIM’s future growth? Take a look at our free research report of analyst consensus for CIM’s outlook.
- Past Track Record: Has CIM 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 CIM’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 email@example.com.