Government Properties Income Trust (NASDAQ:GOV) is trading with a trailing P/E of 32x, which is lower than the industry average of 33.2x. While this makes GOV appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, 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 Government Properties Income Trust
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 GOV
Price-Earnings Ratio = Price per share ÷ Earnings per share
GOV Price-Earnings Ratio = 19.49 ÷ 0.61 = 32x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GOV, 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. GOV’s P/E of 32x is lower than its industry peers (33.2x), which implies that each dollar of GOV’s earnings is being undervalued by investors. Therefore, according to this analysis, GOV is an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy GOV immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to GOV, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with GOV, 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 GOV to are fairly valued by the market. If this does not hold true, GOV’s lower P/E ratio may be because firms in our peer group are expensive by the market.
What this means for you:
Are you a shareholder? 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 GOV. 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.
Are you a potential investor? If GOV 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.