Glanbia plc (ISE:GL9) is trading with a trailing P/E of 17x, which is lower than the industry average of 17.9x. 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Glanbia

What you need to know about the P/E ratio

P/E is a popular ratio used for relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for GL9

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

GL9 Price-Earnings Ratio = €13.7 ÷ €0.804 = 17x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 GL9, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. GL9’s P/E of 17x is lower than its industry peers (17.9x), which implies that each dollar of GL9’s earnings is being undervalued by investors. As such, our analysis shows that GL9 represents an under-priced stock.

A few caveats

Before you jump to the conclusion that GL9 is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to GL9, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with GL9, 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 GL9 to are fairly valued by the market. If this does not hold true, GL9’s lower P/E ratio may be because firms in our peer group are overpriced by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.