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Does G8 Education Limited's (ASX:GEM) P/E Ratio Signal A Buying Opportunity?

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how G8 Education Limited's (ASX:GEM) P/E ratio could help you assess the value on offer. Based on the last twelve months, G8 Education's P/E ratio is 13.51. In other words, at today's prices, investors are paying A$13.51 for every A$1 in prior year profit.

View our latest analysis for G8 Education

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for G8 Education:

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P/E of 13.51 = A$1.99 ÷ A$0.15 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

How Does G8 Education's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that G8 Education has a lower P/E than the average (18.6) P/E for companies in the consumer services industry.

ASX:GEM Price Estimation Relative to Market, November 18th 2019
ASX:GEM Price Estimation Relative to Market, November 18th 2019

This suggests that market participants think G8 Education will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

G8 Education's earnings per share fell by 10% in the last twelve months. But EPS is up 3.9% over the last 5 years. And it has shrunk its earnings per share by 14% per year over the last three years. This could justify a low P/E.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Is Debt Impacting G8 Education's P/E?

G8 Education's net debt equates to 38% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.

The Bottom Line On G8 Education's P/E Ratio

G8 Education's P/E is 13.5 which is below average (18.6) in the AU market. The debt levels are not a major concern, but the lack of EPS growth is likely weighing on sentiment.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than G8 Education. So you may wish to see this free collection of other companies that have grown earnings strongly.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.