GobiMin Inc (TSXV:GMN) is currently trading at a trailing P/E of 2.8x, which is lower than the industry average of 11.1x. 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. See our latest analysis for GMN
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for GMN
Price per share = $0.33
Earnings per share = $0.119
∴ Price-Earnings Ratio = $0.33 ÷ $0.119 = 2.8x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GMN, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 2.8x, GMN’s P/E is lower than its industry peers (11.1x). This implies that investors are undervaluing each dollar of GMN’s earnings. As such, our analysis shows that GMN represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy GMN immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to GMN. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with GMN, then GMN’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with GMN, GMN’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing GMN to are fairly valued by the market. If this assumption is violated, GMN’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:Since you may have already conducted your due diligence on GMN, 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. 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:
1. Financial Health: Is GMN’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
2. Past Track Record: Has GMN been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of GMN’s historicals for more clarity.
3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.