China Cord Blood Corporation (NYSE:CO) is trading with a trailing P/E of 30.6x, which is higher than the industry average of 19.8x. 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 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 Cord Blood
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in relative valuation. 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 CO
Price-Earnings Ratio = Price per share ÷ Earnings per share
CO Price-Earnings Ratio = CN¥72.05 ÷ CN¥2.354 = 30.6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CO, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since CO’s P/E of 30.6x is higher than its industry peers (19.8x), it means that investors are paying more than they should for each dollar of CO’s earnings. As such, our analysis shows that CO represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your CO shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to CO. 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 CO, 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 CO to are fairly valued by the market. If this does not hold, there is a possibility that CO’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.