Canadian Pacific Railway Limited (USA) (NYSE: CP) trades at a P/E multiple of 13.8x, which is lower than the Industrials sector median of 22.9x. While this makes CP appear like a stock to add to your portfolio, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
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Understanding Valuation Multiples and the P/E Ratio
A Multiples Valuation, also known as a Comparable Companies Analysis, determines the value of a subject company by benchmarking the subject's financial performance against similar public companies (Peer Group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Multiple is a valuation ratio that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Multiple = Stock Price ÷ Earnings Per Share
The P/E ratio is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different. I compare Canadian Pacific Railway's P/E multiple to those of Canadian National Railway Company (NYSE: CNI), Genesee & Wyoming, Inc. (NYSE: GWR), Kansas City Southern (NYSE: KSU) and Norfolk Southern Corporation (NYSE: NSC) in the chart below.
Since Canadian Pacific Railway's P/E of 13.8x is higher than the median of its peers (9.9x), it means that investors are paying more than they should for each dollar of CP's earnings. As such, our analysis shows that CP represents an overvalued stock. In fact, finbox.io's P/E Multiple Model calculates a fair value of $147.14 per share which implies -16.8% downside.
Note that the selected multiple of 11.5x in the analysis above was determined by comparing Canadian Pacific Railway's current P/E multiple with its peer group. Canadian Pacific Railway's financial characteristics look most comparable to Kansas City Southern so I took that into consideration as well. Kansas City Southern currently trades at 11.4x earnings as illustrated in more detail below.
Understanding the P/E Ratio's Limitations
Before jumping to the conclusion that Canadian Pacific Railway should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to Canadian Pacific Railway, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare Canadian Pacific Railway with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
Now if the second assumption does not hold true, Canadian Pacific Railway's higher multiple may be because firms in our peer group are being undervalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to CP. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend you to complete your research on Canadian Pacific Railway by taking a look at the following:
Risk Metrics: what is Canadian Pacific Railway's asset efficiency? This ratio measures the amount of cash flow that a company generates from its assets. View the company's asset efficiency here.
Efficiency Metrics: fixed asset turnover is calculated by dividing revenue by average fixed assets. View Canadian Pacific Railway's fixed asset turnover here.
Forecast Metrics: what is Canadian Pacific Railway's projected EBITDA margin? Is the company expected to improve its profitability going forward? Analyze the company's projected EBITDA margin here.
Article by Brian Dentino, Finbox.io