This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Discover Financial Services (NYSE:DFS) trades with a trailing P/E of 12.5x, which is lower than the industry average of 14.5x. While this makes DFS appear like a great stock to buy, 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.
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for DFS
Price per share = $72.74
Earnings per share = $5.803
∴ Price-Earnings Ratio = $72.74 ÷ $5.803 = 12.5x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as DFS, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since DFS’s P/E of 12.5x is lower than its industry peers (14.5x), it means that investors are paying less than they should for each dollar of DFS’s earnings. This multiple is a median of profitable companies of 24 Consumer Finance companies in US including Allied Group, Qudian and Santander Consumer USA Holdings. Therefore, according to this analysis, DFS is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that DFS represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to DFS. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with DFS, then investors would naturally value DFS at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with DFS, investors would also value DFS at a lower price since it is a lower growth investment. Both scenarios would explain why DFS has a lower P/E ratio than its peers. 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, there is a possibility that DFS’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of DFS to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for DFS’s future growth? Take a look at our free research report of analyst consensus for DFS’s outlook.
- Past Track Record: Has DFS 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 DFS’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.