I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Coca-Cola Amatil Limited (ASX:CCL) trades with a trailing P/E of 15.4x, which is lower than the industry average of 26.9x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the Price-Earnings ratio
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.
P/E Calculation for CCL
Price-Earnings Ratio = Price per share ÷ Earnings per share
CCL Price-Earnings Ratio = A$9.79 ÷ A$0.637 = 15.4x
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 CCL, 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. CCL’s P/E of 15.4 is lower than its industry peers (26.9), which implies that each dollar of CCL’s earnings is being undervalued by investors. Since the Beverage sector in AU is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Australian Vintage, Treasury Wine Estates and Gage Roads Brewing. You can think of it like this: the market is suggesting that CCL is a weaker business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to CCL, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CCL, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing CCL to are fairly valued by the market. If this is violated, CCL’s P/E may be lower than its peers as they are actually overvalued by investors.
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 add more of CCL 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. 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 CCL’s future growth? Take a look at our free research report of analyst consensus for CCL’s outlook.
- Past Track Record: Has CCL 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 CCL’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.