GCP Infrastructure Investments Limited (LSE:GCP) is trading with a trailing P/E of 15.6x, which is lower than the industry average of 17x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for GCP Infrastructure Investments
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for GCP
Price per share = 1.28
Earnings per share = 0.082
∴ Price-Earnings Ratio = 1.28 ÷ 0.082 = 15.6x
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 GCP, 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 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.
GCP’s P/E of 15.6x is lower than its industry peers (17x), which implies that each dollar of GCP’s earnings is being undervalued by investors. As such, our analysis shows that GCP represents an under-priced stock.
A few caveats
However, before you rush out to buy GCP, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to GCP. 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 GCP, then investors would naturally value GCP at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with GCP, investors would also value GCP at a lower price since it is a lower growth investment. Both scenarios would explain why GCP has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing GCP to are fairly valued by the market. If this assumption is violated, GCP’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 GCP 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.
Are you a potential investor? If you are considering investing in GCP, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on GCP Infrastructure Investments for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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