Cochlear Limited (ASX:COH) is currently trading at a trailing P/E of 44.2x, which is higher than the industry average of 32.7x. While this makes COH 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Cochlear
Breaking down the Price-Earnings 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 COH
Price-Earnings Ratio = Price per share ÷ Earnings per share
COH Price-Earnings Ratio = A$172.19 ÷ A$3.897 = 44.2x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as COH, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since COH’s P/E of 44.2x is higher than its industry peers (32.7x), it means that investors are paying more than they should for each dollar of COH’s earnings. As such, our analysis shows that COH represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that COH should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to COH, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with COH, 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 COH to are fairly valued by the market. If this is violated, COH’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to COH. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.