CCA Industries Inc (AMEX:CAW) is currently trading at a trailing P/E of 14.7x, which is lower than the industry average of 22.4x. While this makes CAW appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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 CCA Industries
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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 CAW
Price-Earnings Ratio = Price per share ÷ Earnings per share
CAW Price-Earnings Ratio = $3.15 ÷ $0.213 = 14.7x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CAW, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since CAW’s P/E of 14.7x is lower than its industry peers (22.4x), it means that investors are paying less than they should for each dollar of CAW’s earnings. As such, our analysis shows that CAW represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that CAW is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to CAW. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with CAW, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing CAW to are fairly valued by the market. If this does not hold, there is a possibility that CAW’s P/E is lower because our peer group is overvalued by the market.
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.