GigaMedia Limited (NASDAQ:GIGM) is currently trading at a trailing P/E of 25.6x, which is lower than the industry average of 34.8x. 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. In this article, 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 GigaMedia
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 GIGM
Price-Earnings Ratio = Price per share ÷ Earnings per share
GIGM Price-Earnings Ratio = $2.52 ÷ $0.098 = 25.6x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to GIGM, 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. GIGM’s P/E of 25.6x is lower than its industry peers (34.8x), which implies that each dollar of GIGM’s earnings is being undervalued by investors. Therefore, according to this analysis, GIGM is an under-priced stock.
A few caveats
However, before you rush out to buy GIGM, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GIGM. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with GIGM, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing GIGM to are fairly valued by the market. If this does not hold true, GIGM’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on GIGM, the undervaluation of the stock may mean it is a good time to top up on 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:
- Financial Health: Is GIGM’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has GIGM 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 GIGM’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 pass 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.