This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Methode Electronics Inc (NYSE:MEI) is currently trading at a trailing P/E of 20.5x, which is lower than the industry average of 28x. While MEI might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for MEI
Price-Earnings Ratio = Price per share ÷ Earnings per share
MEI Price-Earnings Ratio = $33.2 ÷ $1.619 = 20.5x
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 MEI, 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 20.5, MEI’s P/E is lower than its industry peers (28). This implies that investors are undervaluing each dollar of MEI’s earnings. This multiple is a median of profitable companies of 25 Electronic companies in US including Electro Scientific Industries, Evans & Sutherland Computer and Surge Components. You can think of it like this: the market is suggesting that MEI is a weaker business than the average comparable company.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to MEI, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with MEI, 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 MEI to are fairly valued by the market. If this does not hold true, MEI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to MEI. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for MEI’s future growth? Take a look at our free research report of analyst consensus for MEI’s outlook.
- Past Track Record: Has MEI 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 MEI’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 past 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. For errors that warrant correction please contact the editor at email@example.com.