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CAD IT Sp.A. (BIT:CAD) trades with a trailing P/E of 13.6x, which is lower than the industry average of 26.9x. While this makes CAD 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. View our latest analysis for CAD IT
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 CAD
Price-Earnings Ratio = Price per share ÷ Earnings per share
CAD Price-Earnings Ratio = €5.62 ÷ €0.412 = 13.6x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CAD, 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. CAD’s P/E of 13.6x is lower than its industry peers (26.9x), which implies that each dollar of CAD’s earnings is being undervalued by investors. As such, our analysis shows that CAD represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy CAD immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to CAD. 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 CAD, 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 CAD to are fairly valued by the market. If this does not hold, there is a possibility that CAD’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
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 CAD 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. 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 highly recommend you to complete your research by taking a look at the following: