CarMax, Inc (NYSE: KMX) trades at a P/E multiple of 16.3x, which is lower than the Consumer Discretionary sector median of 19.3x. While this makes KMX 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 calculate CarMax’s fair value using a comparable companies analysis.
Comparable Companies Analysis
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 CarMax's P/E multiple to those of AutoNation, Inc. (NYSE: AN), Penske Automotive Group, Inc. (NYSE: PAG), Lithia Motors Inc (NYSE: LAD) and Sonic Automotive Inc (NYSE: SAH) in the chart below.
Since CarMax's P/E of 16.3x is higher than the median of its peers (9.8x), it means that investors are paying more than they should for each dollar of KMX's earnings. As such, our analysis shows that KMX represents an overvalued stock. Furthermore, finbox.io's P/E Multiple Model calculates a fair value of $51.85 per share which implies -16.3% downside.
Note that the selected multiple of 13.5x in the analysis above was determined by averaging CarMax's current P/E multiple with the highest multiple of its comparable companies (LAD - 10.7x).
Understanding the P/E Ratio's Limitations
Before jumping to the conclusion that CarMax 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 CarMax, 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 CarMax 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. However, CarMax's recent earnings growth has been middle of the road relative to its peers as shown below.
source: P/E model
Now if the second assumption does not hold true, CarMax'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 KMX. 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 that you complete your research on CarMax by taking a look at the following:
Valuation Metrics: how much upside do shares of CarMax have based on Wall Street's consensus price target? Take a look at our analyst upside data explorer that compares the company's upside relative to its peers.
Risk Metrics: what is CarMax'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: inventory turnover is a ratio that measures the number of times a company's inventory is sold and replaced over the year. View CarMax's inventory turnover here.
Article by Andy Pai, Finbox.io