The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Clipper Logistics plc (LON:CLG) trades with a trailing P/E of 20.7x, which is lower than the industry average of 23.7x. While CLG might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Clipper Logistics
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. 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 CLG
Price-Earnings Ratio = Price per share ÷ Earnings per share
CLG Price-Earnings Ratio = £2.94 ÷ £0.142 = 20.7x
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 CLG, 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 20.7, CLG’s P/E is lower than its industry peers (23.7). This implies that investors are undervaluing each dollar of CLG’s earnings. This multiple is a median of profitable companies of 24 Commercial Services companies in GB including Mortice, Communisis and Babcock International Group. One could put it like this: the market is pricing CLG as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to CLG, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CLG, 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 CLG to are fairly valued by the market. If this does not hold, there is a possibility that CLG’s P/E is lower because our peer group is overvalued by the market.