This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Morgan Stanley (NYSE:MS) trades with a trailing P/E of 11.8x, which is lower than the industry average of 17.9x. While this makes MS 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 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 MS
Price per share = $47.35
Earnings per share = $4.006
∴ Price-Earnings Ratio = $47.35 ÷ $4.006 = 11.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to MS, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. 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 11.8x, MS’s P/E is lower than its industry peers (17.9x). This implies that investors are undervaluing each dollar of MS’s earnings. This multiple is a median of profitable companies of 25 Capital Markets companies in US including Modern Technology, Neon Capital and Viking Energy Group. Therefore, according to this analysis, MS is an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy MS immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to MS. 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 MS, then investors would naturally value MS at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with MS, investors would also value MS at a lower price since it is a lower growth investment. Both scenarios would explain why MS has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing MS to are fairly valued by the market. If this assumption is violated, MS’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on MS, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 MS’s future growth? Take a look at our free research report of analyst consensus for MS’s outlook.
- Past Track Record: Has MS 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 MS’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 firstname.lastname@example.org.