GlaxoSmithKline plc (LSE:GSK) is trading with a trailing P/E of 27.2x, which is higher than the industry average of 25.7x. While GSK might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for GlaxoSmithKline
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 pound of the company’s earnings.
P/E Calculation for GSK
Price-Earnings Ratio = Price per share ÷ Earnings per share
GSK Price-Earnings Ratio = £13.02 ÷ £0.478 = 27.2x
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 GSK, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 27.2x, GSK’s P/E is higher than its industry peers (25.7x). This implies that investors are overvaluing each dollar of GSK’s earnings. As such, our analysis shows that GSK represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your GSK shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GSK. 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 GSK, 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 GSK to are fairly valued by the market. If this is violated, GSK’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in GSK. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in GSK, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.