Should You Be Tempted To Buy Discover Financial Services (NYSE:DFS) Because Of Its PE Ratio?
Discover Financial Services (NYSE:DFS) is trading with a trailing P/E of 13.5x, which is lower than the industry average of 14.1x. While DFS 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. See our latest analysis for Discover Financial Services
Breaking down 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 DFS
Price-Earnings Ratio = Price per share ÷ Earnings per share
DFS Price-Earnings Ratio = $78.72 ÷ $5.816 = 13.5x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to DFS, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 13.5x, DFS’s P/E is lower than its industry peers (14.1x). This implies that investors are undervaluing each dollar of DFS’s earnings. Therefore, according to this analysis, DFS is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that DFS is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to DFS, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with DFS, 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 DFS to are fairly valued by the market. If this does not hold true, DFS’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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.
