Merck & Co Inc. (NYSE:MRK) is currently trading at a trailing P/E of 107.7x, which is higher than the industry average of 23.5x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Merck
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 dollar of the company’s earnings.
P/E Calculation for MRK
Price-Earnings Ratio = Price per share ÷ Earnings per share
MRK Price-Earnings Ratio = $62.59 ÷ $0.581 = 107.7x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as MRK, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 107.7x, MRK’s P/E is higher than its industry peers (23.5x). This implies that investors are overvaluing each dollar of MRK’s earnings. Therefore, according to this analysis, MRK is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your MRK shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to MRK. 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 MRK, 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 MRK to are fairly valued by the market. If this does not hold, there is a possibility that MRK’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 MRK, the overvaluation of the stock may mean it is a good time to reduce 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 MRK’s future growth? Take a look at our free research report of analyst consensus for MRK’s outlook.
- Past Track Record: Has MRK 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 MRK’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.