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.
Mylan NV (NASDAQ:MYL) is trading with a trailing P/E of 27.6x, which is higher than the industry average of 23.8x. While MYL might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for MYL
Price per share = $37.31
Earnings per share = $1.354
∴ Price-Earnings Ratio = $37.31 ÷ $1.354 = 27.6x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as MYL, 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 it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
At 27.6x, MYL’s P/E is higher than its industry peers (23.8x). This implies that investors are overvaluing each dollar of MYL’s earnings. This multiple is a median of profitable companies of 25 Pharmaceuticals companies in US including Pharmaxis, Skystar Bio-Pharmaceutical and Bohai Pharmaceuticals Group. As such, our analysis shows that MYL represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your MYL shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to MYL. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with MYL, then MYL’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with MYL. In this case, MYL’s P/E would be higher since investors would also reward MYL’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing MYL to are fairly valued by the market. If this does not hold, there is a possibility that MYL’s P/E is higher because firms in our peer group are being undervalued 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 MYL. 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 MYL’s future growth? Take a look at our free research report of analyst consensus for MYL’s outlook.
- Past Track Record: Has MYL 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 MYL’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.