Cambridge Technology Enterprises Limited (NSEI:CTE) trades with a trailing P/E of 10.9x, which is lower than the industry average of 19.8x. While CTE 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.
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CTE
Price per share = ₹84.8
Earnings per share = ₹7.761
∴ Price-Earnings Ratio = ₹84.8 ÷ ₹7.761 = 10.9x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CTE, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
CTE’s P/E of 10.9x is lower than its industry peers (19.8x), which implies that each dollar of CTE’s earnings is being undervalued by investors. As such, our analysis shows that CTE represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy CTE immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CTE. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with CTE, then investors would naturally value CTE at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with CTE, investors would also value CTE at a lower price since it is a lower growth investment. Both scenarios would explain why CTE has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CTE to are fairly valued by the market. If this assumption does not hold true, CTE’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.