Cummins Inc. (NYSE: CMI) shares currently trade at 24.1x trailing earnings which is higher than the Industrials sector median of 22.2x. While this makes CMI look like a stock to avoid or sell if you own it, 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.
CMI 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 CMI’s P/E ratio to its peer group that includes Deere & Company (NYSE: DE), Caterpillar, Inc. (NYSE: CAT), CNH Industrial N.V. (NYSE: CNHI) and Navistar International Corporation (NYSE: NAV).
Since CMI’s P/E of 24.1x is lower than the median of its peers (35.1x), it means that investors are paying less than they should for each dollar of CMI’s earnings. As such, our analysis shows that CMI represents an undervalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of roughly $150.50 per share which implies around 12.5% upside.
I selected a fair multiple of 27.1x in my analysis by averaging CMI’s current P/E ratio with its peer group.
Are Peers Really Comparable?
Before concluding that CMI 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 CMI, 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 CMI 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
However, if the second assumption does not hold true, CMI’s lower multiple may be because firms in our peer group are being overvalued by the market.
How This Impacts Shareholders
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 CMI. 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 CMI by taking a look at the following:
Valuation Metrics: what is CMI’s price to book ratio and how does it compare to its peers? Analyze Price / Book here.
Risk Metrics: what is CMI’s CapEx coverage? This is the amount a company outlays for capital assets for each dollar it generates from those investments. View the company’s CapEx coverage 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 CMI’s inventory turnover 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.