China Green Agriculture Inc (NYSE:CGA) trades with a trailing P/E of 2.5x, which is lower than the industry average of 21.1x. While this makes CGA appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for China Green Agriculture
Breaking down the P/E 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 CGA
Price-Earnings Ratio = Price per share ÷ Earnings per share
CGA Price-Earnings Ratio = $1.5 ÷ $0.599 = 2.5x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CGA, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 2.5x, CGA’s P/E is lower than its industry peers (21.1x). This implies that investors are undervaluing each dollar of CGA’s earnings. As such, our analysis shows that CGA represents an under-priced stock.
A few caveats
Before you jump to the conclusion that CGA 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 CGA. 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 CGA, 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 CGA to are fairly valued by the market. If this is violated, CGA’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of CGA to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in CGA, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
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 China Green Agriculture 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.