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.
Core-Mark Holding Company Inc (NASDAQ:CORE) is trading with a trailing P/E of 45.7, which is higher than the industry average of 22.6. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. 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.
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 CORE
Price-Earnings Ratio = Price per share ÷ Earnings per share
CORE Price-Earnings Ratio = $33.83 ÷ $0.740 = 45.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CORE, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 45.7, CORE’s P/E is higher than its industry peers (22.6). This implies that investors are overvaluing each dollar of CORE’s earnings. This multiple is a median of profitable companies of 17 Retail Distributors companies in US including Xinhua Winshare Publishing and Media, Inchcape and Inchcape. You could think of it like this: the market is pricing CORE as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to CORE. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Core-Mark Holding Company Inc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to CORE may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
Since you may have already conducted your due diligence on CORE, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 CORE’s future growth? Take a look at our free research report of analyst consensus for CORE’s outlook.
- Past Track Record: Has CORE 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 CORE’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.