Does Gem Diamonds Limited’s (LON:GEMD) PE Ratio Warrant A Sell?
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Gem Diamonds Limited (LON:GEMD) trades with a trailing P/E of 37.3, which is higher than the industry average of 9.7. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
See our latest analysis for Gem Diamonds
What you need to know about 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.
P/E Calculation for GEMD
Price-Earnings Ratio = Price per share ÷ Earnings per share
GEMD Price-Earnings Ratio = $1.48 ÷ $0.0396 = 37.3x
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 GEMD, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. GEMD’s P/E of 37.3 is higher than its industry peers (9.7), which implies that each dollar of GEMD’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Metals and Mining companies in GB including Cora Gold, Patagonia Gold and En+ Group. You could think of it like this: the market is pricing GEMD as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to GEMD. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Gem Diamonds Limited is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to GEMD may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
Since you may have already conducted your due diligence on GEMD, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 urge you to complete your research by taking a look at the following:
Future Outlook: What are well-informed industry analysts predicting for GEMD’s future growth? Take a look at our free research report of analyst consensus for GEMD’s outlook.
Past Track Record: Has GEMD 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 GEMD’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 editorial-team@simplywallst.com.
