Mesabi Trust (NYSE:MSB) is trading with a trailing P/E of 12x, which is lower than the industry average of 23.4x. While this makes MSB appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Mesabi Trust
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for MSB
Price per share = 22.05
Earnings per share = 1.837
∴ Price-Earnings Ratio = 22.05 ÷ 1.837 = 12x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as MSB, 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. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since MSB's P/E of 12x is lower than its industry peers (23.4x), it means that investors are paying less than they should for each dollar of MSB's earnings. As such, our analysis shows that MSB represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy MSB immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to MSB. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with MSB, then investors would naturally value MSB at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with MSB, investors would also value MSB at a lower price since it is a lower growth investment. Both scenarios would explain why MSB has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing MSB to are fairly valued by the market. If this does not hold, there is a possibility that MSB’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on MSB, 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.
Are you a potential investor? If MSB has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Mesabi Trust for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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.