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.
Chicago Rivet & Machine Co (NYSEMKT:CVR) is trading with a trailing P/E of 12.5x, which is lower than the industry average of 23.3x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 CVR
Price-Earnings Ratio = Price per share ÷ Earnings per share
CVR Price-Earnings Ratio = $32.48 ÷ $2.605 = 12.5x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CVR, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. CVR’s P/E of 12.5 is lower than its industry peers (23.3), which implies that each dollar of CVR’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Machinery companies in US including Eco Energy Tech Asia, Hebron Technology and EnPro Industries. You can think of it like this: the market is suggesting that CVR is a weaker business than the average comparable company.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to CVR. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with CVR, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CVR to are fairly valued by the market. If this is violated, CVR’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to CVR. 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 CVR’s future growth? Take a look at our free research report of analyst consensus for CVR’s outlook.
- Past Track Record: Has CVR 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 CVR’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.