I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
BMTC Group Inc (TSE:GBT) is trading with a trailing P/E of 11.8, which is lower than the industry average of 14.8. While this makes GBT appear like a good stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 GBT
Price per share = CA$14.82
Earnings per share = CA$1.254
∴ Price-Earnings Ratio = CA$14.82 ÷ CA$1.254 = 11.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to GBT, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 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 11.8, GBT’s P/E is lower than its industry peers (14.8). This implies that investors are undervaluing each dollar of GBT’s earnings. This multiple is a median of profitable companies of 6 Specialty Retail companies in CA including Advent-AWI Holdings, Leon’s Furniture and Roots. You can think of it like this: the market is suggesting that GBT is a weaker business than the average comparable company.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to GBT. 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 GBT, then GBT’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 GBT, GBT’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 GBT to are fairly valued by the market. If this assumption is violated, GBT’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 GBT, 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for GBT’s future growth? Take a look at our free research report of analyst consensus for GBT’s outlook.
- Past Track Record: Has GBT 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 GBT’s historicals for more clarity.
- 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.
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.