This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
The Goldman Sachs Group Inc (NYSE:GS) trades with a trailing P/E of 17, which is lower than the industry average of 22.6. While this makes GS appear like a good stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 GS
Price per share = $215.22
Earnings per share = $12.673
∴ Price-Earnings Ratio = $215.22 ÷ $12.673 = 17x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 GS, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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 17, GS’s P/E is lower than its industry peers (22.6). This implies that investors are undervaluing each dollar of GS’s earnings. This multiple is a median of profitable companies of 24 Capital Markets companies in US including Viking Energy Group, TheStreet and China Internet Nationwide Financial Services. One could put it like this: the market is pricing GS as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two important assertions. The first is that our peer group actually contains companies that are similar to GS. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with GS, then investors would naturally value GS at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with GS, investors would also value GS at a lower price since it is a lower growth investment. Both scenarios would explain why GS has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing GS to are fairly valued by the market. If this assumption is violated, GS’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of GS to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 GS’s future growth? Take a look at our free research report of analyst consensus for GS’s outlook.
- Past Track Record: Has GS 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 GS’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.