In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Columbia Sportswear Company (NASDAQ:COLM) is trading with a trailing P/E of 47.1, which is higher than the industry average of 21.9. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. 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 Columbia Sportswear
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 COLM
Price-Earnings Ratio = Price per share ÷ Earnings per share
COLM Price-Earnings Ratio = $91.2 ÷ $1.937 = 47.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 COLM, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 47.1, COLM’s P/E is higher than its industry peers (21.9). This implies that investors are overvaluing each dollar of COLM’s earnings. This multiple is a median of profitable companies of 25 Luxury companies in US including Kingold Jewelry, Vince Holding and Ever-Glory International Group. You could also say that the market is suggesting that COLM is a stronger business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to COLM. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Columbia Sportswear Company is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with COLM are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on COLM, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 urge you to complete your research by taking a look at the following: