G4S plc (LSE:GFS) trades with a trailing P/E of 15.7x, which is higher than the industry average of 13.6x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for G4S

Demystifying the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 pound of the company’s earnings.

P/E Calculation for GFS

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

GFS Price-Earnings Ratio = £2.9 ÷ £0.184 = 15.7x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to GFS, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since GFS’s P/E of 15.7x is higher than its industry peers (13.6x), it means that investors are paying more than they should for each dollar of GFS’s earnings. As such, our analysis shows that GFS represents an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your GFS shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to GFS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with GFS, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing GFS to are fairly valued by the market. If this does not hold true, GFS’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on GFS, the overvaluation of the stock may mean it is a good time to reduce 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 GFS 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.