In This Article:
I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Gale Pacific Limited (ASX:GAP) trades with a trailing P/E of 10.6x, which is lower than the industry average of 12x. While this makes GAP appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
View our latest analysis for Gale Pacific
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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 GAP
Price-Earnings Ratio = Price per share ÷ Earnings per share
GAP Price-Earnings Ratio = A$0.35 ÷ A$0.0335 = 10.6x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GAP, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. GAP’s P/E of 10.6 is lower than its industry peers (12), which implies that each dollar of GAP’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 8 Consumer Durables companies in AU including Shriro Holdings, Quantum Energy and Fleetwood. One could put it like this: the market is pricing GAP as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GAP. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with GAP, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing GAP to are fairly valued by the market. If this does not hold true, GAP’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to GAP. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: