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Bank of Montreal (TSX:BMO) is currently trading at a trailing P/E of 14.2x, which is higher than the industry average of 12.8x. While this makes BMO appear like a stock to avoid or sell if you own it, 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. See our latest analysis for Bank of Montreal
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 BMO
Price-Earnings Ratio = Price per share ÷ Earnings per share
BMO Price-Earnings Ratio = CA$101.64 ÷ CA$7.17 = 14.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 BMO, 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 BMO’s P/E of 14.2x is higher than its industry peers (12.8x), it means that investors are paying more than they should for each dollar of BMO’s earnings. As such, our analysis shows that BMO represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your BMO shares, 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 BMO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with BMO, 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 BMO to are fairly valued by the market. If this does not hold, there is a possibility that BMO’s P/E is lower because our peer group is 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 overvaluation could signal a potential selling opportunity to reduce your exposure to BMO. 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 BMO’s future growth? Take a look at our free research report of analyst consensus for BMO’s outlook.
Past Track Record: Has BMO 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 BMO’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.