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.
Graham Holdings Company (NYSE:GHC) trades with a trailing P/E of 9.4x, which is lower than the industry average of 24.6x. While this makes GHC appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 GHC
Price-Earnings Ratio = Price per share ÷ Earnings per share
GHC Price-Earnings Ratio = $564.2 ÷ $59.877 = 9.4x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GHC, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. GHC’s P/E of 9.4 is lower than its industry peers (24.6), which implies that each dollar of GHC’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Consumer Services companies in US including Kid Castle Educational, ATA and H&R Block. You can think of it like this: the market is suggesting that GHC is a weaker business than the average comparable company.
Assumptions to be aware of
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 GHC. 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 GHC, 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 GHC to are fairly valued by the market. If this does not hold true, GHC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 GHC. 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:
- Future Outlook: What are well-informed industry analysts predicting for GHC’s future growth? Take a look at our free research report of analyst consensus for GHC’s outlook.
- Past Track Record: Has GHC 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 GHC’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 email@example.com.