This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Gazal Corporation Limited (ASX:GZL) trades with a trailing P/E of 20.1, which is higher than the industry average of 10.5. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Gazal
Demystifying 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 GZL
Price-Earnings Ratio = Price per share ÷ Earnings per share
GZL Price-Earnings Ratio = A$4.59 ÷ A$0.228 = 20.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to GZL, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. GZL’s P/E of 20.1 is higher than its industry peers (10.5), which implies that each dollar of GZL’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 4 Luxury companies in AU including XPD Soccer Gear Group, GLG and Globe International. You could also say that the market is suggesting that GZL is a stronger business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to GZL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Gazal Corporation Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with GZL are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on GZL, 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. 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: