CME Group Inc (NASDAQ: CME) trades at a P/E multiple of 13.5x, which is lower than the Financials sector median of 18.9x. While this makes CME 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.
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 CME Group’s P/E multiple to those of Intercontinental Exchange Inc. (NYSE: ICE), Nasdaq, Inc.(NASDAQ: NDAQ), CBOE Holdings, Inc. (NASDAQ: CBOE) and S&P Global Inc. (NYSE: SPGI) in the chart below.
Since CME Group’s P/E of 13.5x is lower than the median of its peers (25.7x), it means that investors are paying less than they should for each dollar of CME’s earnings. As such, our analysis shows that CME represents an undervalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of $231.58 per share which implies 46.8% upside.
Note that the selected multiple of 19.4x in the analysis above was determined by averaging CME Group’s current P/E multiple with its peer group and sector.
Understanding the P/E Ratio’s Limitations
Before jumping to the conclusion that CME Group should be added to 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 CME Group, 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 CME Group with higher growth companies, then its P/E multiple would naturally be lower 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, CME Group’s lower multiple may be because firms in our peer group are being overvalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current undervaluation could signal a potential buying opportunity to increase your position in CME. 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 CME Group by taking a look at the following:
Valuation Metrics: what is CME Group’s price to book ratio and how does it compare to its peers? Analyze Price / Book here.
Risk Metrics: what is CME Group’s Altman Z score? It’s a famous formula used to predict the probability that a firm will go into bankruptcy within two years. View the company’s Altman Z score here.
Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View CME Group’s return on equity here.
Author: Andy Pai
Expertise: financial modeling, mergers & acquisitions
Andy is also a founder at finbox.io, where he’s focused on building tools that make it faster and easier for investors to do investment research. Andy’s background is in investment banking where he led the analysis on over 50 board advisory engagements involving mergers and acquisitions, fairness opinions and solvency opinions. Some of his board advisory highlights:
- Sears Holdings Corp.’s $620 mm spin-off via rights offering of Sears Outlet, Hometown Stores and Sears Hardware Stores.
- Cerberus Capital Management’s $3.3 bn acquisition of SUPERVALU Inc.’s New Albertsons, Inc. assets.
Andy can be reached at email@example.com.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.