Cyanotech Corporation (NASDAQ:CYAN) trades with a trailing P/E of 61.1x, which is higher than the industry average of 22.4x. While this makes CYAN 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. View our latest analysis for Cyanotech
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in 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 CYAN
Price-Earnings Ratio = Price per share ÷ Earnings per share
CYAN Price-Earnings Ratio = $3.81 ÷ $0.062 = 61.1x
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 CYAN, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since CYAN’s P/E of 61.1x is higher than its industry peers (22.4x), it means that investors are paying more than they should for each dollar of CYAN’s earnings. As such, our analysis shows that CYAN represents an over-priced stock.
A few caveats
However, before you rush out to sell your CYAN 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 CYAN, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with CYAN, 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 CYAN to are fairly valued by the market. If this is violated, CYAN’s P/E may be lower than its peers as they are actually overvalued by investors.
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.