U.S. Markets closed

I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.

The Go-Ahead Group plc (LON:GOG) is trading with a trailing P/E of 7.3x, which is lower than the industry average of 11.7x. 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.

### 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 dollar of the company’s earnings.

P/E Calculation for GOG

Price-Earnings Ratio = Price per share ÷ Earnings per share

GOG Price-Earnings Ratio = £15.07 ÷ £2.072 = 7.3x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GOG, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 7.3, GOG’s P/E is lower than its industry peers (11.7). This implies that investors are undervaluing each dollar of GOG’s earnings. This multiple is a median of profitable companies of 6 Transportation companies in GB including Rotala, Northgate and Stagecoach Group. You can think of it like this: the market is suggesting that GOG is a weaker business than the average comparable company.

### Assumptions to watch out for

However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GOG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with GOG, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing GOG to are fairly valued by the market. If this is violated, GOG’s P/E may be lower than its peers as they are actually overvalued by investors.

### What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to GOG. 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 highly recommend you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for GOG’s future growth? Take a look at our free research report of analyst consensus for GOG’s outlook.
2. Past Track Record: Has GOG 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 GOG’s historicals for more clarity.
3. 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.