Is G8 Education Limited's (ASX:GEM) P/E Ratio Really That Good?

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to G8 Education Limited's (ASX:GEM), to help you decide if the stock is worth further research. G8 Education has a P/E ratio of 12.66, based on the last twelve months. In other words, at today's prices, investors are paying A$12.66 for every A$1 in prior year profit.

View our latest analysis for G8 Education

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for G8 Education:

P/E of 12.66 = AUD1.86 ÷ AUD0.15 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each AUD1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.

How Does G8 Education's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that G8 Education has a lower P/E than the average (18.8) P/E for companies in the consumer services industry.

G8 Education's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

G8 Education's earnings per share fell by 10% in the last twelve months. But EPS is up 3.9% over the last 5 years. And over the longer term (3 years) earnings per share have decreased 14% annually. This growth rate might warrant a low P/E ratio.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

G8 Education's Balance Sheet

G8 Education has net debt equal to 40% of its market cap. While that's enough to warrant consideration, it doesn't really concern us.

The Bottom Line On G8 Education's P/E Ratio

G8 Education's P/E is 12.7 which is below average (18.8) in the AU market. The debt levels are not a major concern, but the lack of EPS growth is likely weighing on sentiment.

When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

But note: G8 Education may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.