The Coca-Cola Company (NYSE:KO) is trading with a trailing P/E of 142.7x, which is higher than the industry average of 23.9x. While this makes KO appear like a stock to avoid or sell if you own it, 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. See our latest analysis for Coca-Cola
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 KO
Price-Earnings Ratio = Price per share ÷ Earnings per share
KO Price-Earnings Ratio = $42.14 ÷ $0.295 = 142.7x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as KO, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. KO’s P/E of 142.7x is higher than its industry peers (23.9x), which implies that each dollar of KO’s earnings is being overvalued by investors. As such, our analysis shows that KO represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your KO shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to KO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with KO, 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 KO to are fairly valued by the market. If this does not hold true, KO’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on KO, 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for KO’s future growth? Take a look at our free research report of analyst consensus for KO’s outlook.
- Past Track Record: Has KO 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 KO’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 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.