General Motors Company (NYSE:GM) is currently trading at a trailing P/E of 163.3x, which is higher than the industry average of 10.5x. While GM might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 General Motors
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 GM
Price per share = $37.01
Earnings per share = $0.227
∴ Price-Earnings Ratio = $37.01 ÷ $0.227 = 163.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to GM, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 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.
Since GM's P/E of 163.3x is higher than its industry peers (10.5x), it means that investors are paying more than they should for each dollar of GM's earnings. As such, our analysis shows that GM represents an over-priced stock.
A few caveats
However, before you rush out to sell your GM shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to GM. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with GM, then investors would naturally value GM at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with GM, investors would also value GM at a higher price since it is a higher growth investment. Both scenarios would explain why GM has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing GM to are fairly valued by the market. If this assumption is violated, GM's P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to GM. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for GM’s future growth? Take a look at our free research report of analyst consensus for GM’s outlook.
- Past Track Record: Has GM 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 GM'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.
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.
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