New Concept Energy Inc (AMEX:GBR) is trading with a trailing P/E of 8.7x, which is lower than the industry average of 20.8x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for New Concept Energy
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
P/E Calculation for GBR
Price-Earnings Ratio = Price per share ÷ Earnings per share
GBR Price-Earnings Ratio = 1.22 ÷ 0.14 = 8.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to GBR, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since GBR’s P/E of 8.7x is lower than its industry peers (20.8x), it means that investors are paying less than they should for each dollar of GBR’s earnings. Therefore, according to this analysis, GBR is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy GBR immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to GBR, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with GBR, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing GBR to are fairly valued by the market. If this is violated, GBR’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on GBR, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If GBR has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.