Microsoft Corporation (NASDAQ:MSFT) is trading with a trailing P/E of 76.1x, which is higher than the industry average of 34.2x. While MSFT 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. 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. See our latest analysis for Microsoft
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for MSFT
Price per share = $94.18
Earnings per share = $1.237
∴ Price-Earnings Ratio = $94.18 ÷ $1.237 = 76.1x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to MSFT, 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 76.1x, MSFT’s P/E is higher than its industry peers (34.2x). This implies that investors are overvaluing each dollar of MSFT’s earnings. As such, our analysis shows that MSFT represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your MSFT shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to MSFT. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with MSFT, then MSFT’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 MSFT. In this case, MSFT’s P/E would be higher since investors would also reward MSFT’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing MSFT to are fairly valued by the market. If this assumption is violated, MSFT’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 rebalance your portfolio and reduce your holdings in MSFT. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for MSFT’s future growth? Take a look at our free research report of analyst consensus for MSFT’s outlook.
- Past Track Record: Has MSFT 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 MSFT’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.
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