This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Continental Aktiengesellschaft (FRA:CON) is currently trading at a trailing P/E of 9.7x, which is lower than the industry average of 13.7x. 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. In this article, 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
A common ratio used for relative valuation is the P/E ratio. 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 CON
Price-Earnings Ratio = Price per share ÷ Earnings per share
CON Price-Earnings Ratio = €148.2 ÷ €15.243 = 9.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CON, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 9.7, CON’s P/E is lower than its industry peers (13.7). This implies that investors are undervaluing each dollar of CON’s earnings. This multiple is a median of profitable companies of 15 Auto Components companies in DE including American Axle & Manufacturing Holdings, Schaeffler and LEONI. You can think of it like this: the market is suggesting that CON is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to CON. 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 CON, 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 CON to are fairly valued by the market. If this does not hold true, CON’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 CON 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for CON’s future growth? Take a look at our free research report of analyst consensus for CON’s outlook.
- Past Track Record: Has CON 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 CON’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.