Yahoo Finance Does Diageo plc’s (LON:DGE) PE Ratio Signal A Buying Opportunity?
Diageo plc (LSE:DGE) is currently trading at a trailing P/E of 21.4x, which is lower than the industry average of 25.2x. While this makes DGE 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 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 Diageo
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 DGE
Price-Earnings Ratio = Price per share ÷ Earnings per share
DGE Price-Earnings Ratio = £27.37 ÷ £1.278 = 21.4x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to DGE, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 21.4x, DGE’s P/E is lower than its industry peers (25.2x). This implies that investors are undervaluing each dollar of DGE’s earnings. As such, our analysis shows that DGE represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy DGE immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to DGE, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with DGE, 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 DGE to are fairly valued by the market. If this does not hold, there is a possibility that DGE’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on DGE, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. 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 urge you to complete your research by taking a look at the following:
Future Outlook: What are well-informed industry analysts predicting for DGE’s future growth? Take a look at our free research report of analyst consensus for DGE’s outlook.
Past Track Record: Has DGE 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 DGE’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 pass 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.
