This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
GrainCorp Limited (ASX:GNC) is currently trading at a trailing P/E of 25.6, which is higher than the industry average of 19. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the Price-Earnings 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 dollar of the company’s earnings.
P/E Calculation for GNC
Price-Earnings Ratio = Price per share ÷ Earnings per share
GNC Price-Earnings Ratio = A$8 ÷ A$0.312 = 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 GNC, 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. Since GNC’s P/E of 25.6 is higher than its industry peers (19), it means that investors are paying more for each dollar of GNC’s earnings. This multiple is a median of profitable companies of 20 Food companies in AU including Jiajiafu Modern Agriculture, Bojun Agriculture Holdings and Dongfang Modern Agriculture Holding Group. You could also say that the market is suggesting that GNC is a stronger business than the average comparable company.
Assumptions to watch out for
However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to GNC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if GrainCorp 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 GNC 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 GNC, 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 GNC’s future growth? Take a look at our free research report of analyst consensus for GNC’s outlook.
- Past Track Record: Has GNC 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 GNC’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 firstname.lastname@example.org.