Should You Be Tempted To Sell The Go-Ahead Group plc (LON:GOG) Because Of Its P/E Ratio?

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use The Go-Ahead Group plc's (LON:GOG) P/E ratio to inform your assessment of the investment opportunity. Go-Ahead Group has a P/E ratio of 15.95, based on the last twelve months. That means that at current prices, buyers pay £15.95 for every £1 in trailing yearly profits.

Check out our latest analysis for Go-Ahead Group

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Go-Ahead Group:

P/E of 15.95 = £21.82 ÷ £1.37 (Based on the trailing twelve months to June 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Does Go-Ahead Group'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 Go-Ahead Group has a higher P/E than the average (8.6) P/E for companies in the transportation industry.

That means that the market expects Go-Ahead Group will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Go-Ahead Group saw earnings per share decrease by 34% last year. And over the longer term (5 years) earnings per share have decreased 3.6% annually. This might lead to muted expectations.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Go-Ahead Group's Balance Sheet

Go-Ahead Group has net cash of UK£224m. This is fairly high at 24% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.

The Bottom Line On Go-Ahead Group's P/E Ratio

Go-Ahead Group trades on a P/E ratio of 16.0, which is below the GB market average of 18.3. The recent drop in earnings per share would make investors cautious, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.

Investors have an opportunity when market expectations about a stock are wrong. 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.

You might be able to find a better buy than Go-Ahead Group. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.