I am writing today to help inform people who are new to the stock market and want to better understand how you can grow your money by investing in The Goldman Sachs Group Inc (NYSE:GS).
The Goldman Sachs Group Inc (NYSE:GS) is currently trading at a trailing P/E of 20.6x, which is higher than the industry average of 15.9x. While this makes GS appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View out our latest analysis for Goldman Sachs Group
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 GS
Price per share = $220.18
Earnings per share = $10.704
∴ Price-Earnings Ratio = $220.18 ÷ $10.704 = 20.6x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 common peer group is companies that exist in the same industry, which is what I use below. 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.
Since GS’s P/E of 20.6x is higher than its industry peers (15.9x), it means that investors are paying more than they should for each dollar of GS’s earnings. As such, our analysis shows that GS represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your GS shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to GS. 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 GS, then investors would naturally value GS at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with GS, investors would also value GS at a higher price since it is a higher growth investment. Both scenarios would explain why GS has a higher 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 does not hold, there is a possibility that GS’s P/E is higher because firms in our peer group are being undervalued by the market.
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 GS. 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 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.