Gazal Corporation Limited (ASX:GZL) is trading with a trailing P/E of 12.3x, which is lower than the industry average of 19.3x. While GZL might seem like an attractive stock to buy, 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. See our latest analysis for GZL
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. 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 GZL
Price-Earnings Ratio = Price per share ÷ Earnings per share
GZL Price-Earnings Ratio = A$2.2 ÷ A$0.179 = 12.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to GZL, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. GZL’s P/E of 12.3x is lower than its industry peers (19.3x), which implies that each dollar of GZL’s earnings is being undervalued by investors. As such, our analysis shows that GZL represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy GZL, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GZL. 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 GZL, 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 GZL to are fairly valued by the market. If this does not hold true, GZL’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 add more of GZL to your portfolio. 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 GZL, 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.