Globe International Limited (ASX:GLB) trades with a trailing P/E of 7.9x, which is lower than the industry average of 12.8x. While GLB might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for GLB

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for GLB

Price per share = 0.97

Earnings per share = 0.123

∴ Price-Earnings Ratio = 0.97 ÷ 0.123 = 7.9x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GLB, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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.

GLB’s P/E of 7.9x is lower than its industry peers (12.8x), which implies that each dollar of GLB’s earnings is being undervalued by investors. Therefore, according to this analysis, GLB is an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy GLB immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to GLB. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with GLB, then GLB’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with GLB, GLB’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing GLB to are fairly valued by the market. If this assumption is violated, GLB's P/E may be lower than its peers because its peers are actually overvalued by investors.