Medidata Solutions Inc (NASDAQ:MDSO) trades with a trailing P/E of 90.1x, which is higher than the industry average of 44.6x. While this makes MDSO 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. 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 Medidata Solutions
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in relative valuation. 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 MDSO
Price-Earnings Ratio = Price per share ÷ Earnings per share
MDSO Price-Earnings Ratio = $66.38 ÷ $0.737 = 90.1x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to MDSO, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since MDSO’s P/E of 90.1x is higher than its industry peers (44.6x), it means that investors are paying more than they should for each dollar of MDSO’s earnings. Therefore, according to this analysis, MDSO is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that MDSO should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to MDSO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with MDSO, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing MDSO to are fairly valued by the market. If this is violated, MDSO’s P/E may be lower than its peers as they are actually overvalued by investors.
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.