Deere & Company (NYSE:DE) is currently trading at a trailing P/E of 20.3x, which is lower than the industry average of 27.4x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. 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. Check out our latest analysis for Deere
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 dollar of the company’s earnings.
P/E Calculation for DE
Price-Earnings Ratio = Price per share ÷ Earnings per share
DE Price-Earnings Ratio = 123.66 ÷ 6.085 = 20.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as DE, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since DE's P/E of 20.3x is lower than its industry peers (27.4x), it means that investors are paying less than they should for each dollar of DE's earnings. Therefore, according to this analysis, DE is an under-priced stock.
A few caveats
However, before you rush out to buy DE, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to DE. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with DE, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DE to are fairly valued by the market. If this does not hold, there is a possibility that DE’s P/E is lower because our peer group is 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 DE 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 DE, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
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 Deere 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.