G8 Education Limited (ASX:GEM) is currently trading at a trailing P/E of 19.5x, which is lower than the industry average of 20.6x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for G8 Education
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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 GEM
Price-Earnings Ratio = Price per share ÷ Earnings per share
GEM Price-Earnings Ratio = 4.27 ÷ 0.219 = 19.5x
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 GEM, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since GEM's P/E of 19.5x is lower than its industry peers (20.6x), it means that investors are paying less than they should for each dollar of GEM's earnings. As such, our analysis shows that GEM represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy GEM immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to GEM, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with GEM, 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 GEM to are fairly valued by the market. If this does not hold, there is a possibility that GEM’s P/E is lower because our peer group is overpriced by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on GEM, 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 you are considering investing in GEM, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.