Is It Time To Buy G4S plc (LON:GFS) Based Off Its PE Ratio?

G4S plc (LSE:GFS) is currently trading at a trailing P/E of 15.5x, which is lower than the industry average of 20x. While GFS might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for G4S

Breaking down 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 pound of the company’s earnings.

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with 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 GFS, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.

GFS’s P/E of 15.5x is lower than its industry peers (20x), which implies that each dollar of GFS’s earnings is being undervalued by investors. Therefore, according to this analysis, GFS is an under-priced stock.

A few caveats

Before you jump to the conclusion that GFS represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to GFS. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with GFS, then investors would naturally value GFS at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with GFS, investors would also value GFS at a lower price since it is a lower growth investment. Both scenarios would explain why GFS has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing GFS to are fairly valued by the market. If this assumption does not hold true, GFS’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.

What this means for you:

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 GFS. 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. 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:

1. Future Outlook: What are well-informed industry analysts predicting for GFS’s future growth? Take a look at our free research report of analyst consensus for GFS’s outlook.
2. Past Track Record: Has GFS 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 GFS'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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.