Canadian National Railway (NYSE: CNI) shares currently trade at 14.5x trailing earnings which is lower than the Industrials sector median of 22.8x. While this makes CNI look like a stock to add to your portfolio, equity investors might change their mind after taking a closer look at the assumptions behind the P/E ratio. In this article, I define how to calculate a P/E multiple and what to keep an eye out for when applying it in a comparable companies analysis.
Canadian National Railway Comparable Companies Analysis
A comparable companies analysis, also known as a multiples valuation, determines the value of a subject company by benchmarking its financial performance against similar public companies or peers. We can conclude if a company looks undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation ratios.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare Canadian National Railway’s P/E ratio to its peer group that includes Canadian Pacific Railway Limited (NYSE: CP), Norfolk Southern Corporation (NYSE: NSC), Union Pacific Corporation (NYSE: UNP) and Kansas City Southern (NYSE: KSU).
Since Canadian National Railway’s P/E of 14.5x is higher than the median of its peers (11.1x), it means that investors are paying more than they should for each dollar of CNI’s earnings. As such, our analysis shows that CNI represents an overvalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of roughly $67.50 per share which implies around 18.5% downside.
I selected a fair multiple of 11.8x in my analysis by averaging Canadian National Railway’s current P/E ratio with its peer group.
Are Peers Really Comparable?
Before concluding that Canadian National 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 National 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 National 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
However, if the second assumption does not hold true, Canadian National Railway’s higher multiple may be because firms in our peer group are being undervalued by the market.
How This Impacts Shareholders
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 CNI. 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 Canadian National Railway by taking a look at the following:
Valuation Metrics: how much upside do shares of Canadian National Railway have based on the Ben Graham Formula? Take a look at our Ben Graham Formula data explorer which also compares the company’s upside to its peers.
Risk Metrics: what is Canadian National Railway’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: how much free cash flow does Canadian National Railway generate as a percentage of total sales? Has it been increasing or decreasing over time? Review the firm’s free cash flow margin here.
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.