When Should You Sell Canadian Utilities Limited (TSX:CU)?
Canadian Utilities Limited (TSX:CU) is trading with a trailing P/E of 18.1x, which is higher than the industry average of 17.9x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, 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. View our latest analysis for Canadian Utilities
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 CU
Price-Earnings Ratio = Price per share ÷ Earnings per share
CU Price-Earnings Ratio = 38.75 ÷ 2.144 = 18.1x
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 CU, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since CU's P/E of 18.1x is higher than its industry peers (17.9x), it means that investors are paying more than they should for each dollar of CU's earnings. Therefore, according to this analysis, CU is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CU should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to CU, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with CU, 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 CU to are fairly valued by the market. If this does not hold, there is a possibility that CU’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on CU, 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.
Are you a potential investor? If CU has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Canadian Utilities for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass 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.
