Is Microsoft Corporation (NASDAQ:MSFT) A Sell At Its Current PE Ratio?

This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between Microsoft Corporation (NASDAQ:MSFT)’s fundamentals and stock market performance.

Microsoft Corporation (NASDAQ:MSFT) is trading with a trailing P/E of 66.1x, which is higher than the industry average of 38x. While this makes MSFT 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. Check out our latest analysis for Microsoft

What you need to know about the P/E ratio

NasdaqGS:MSFT PE PEG Gauge June 27th 18

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.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for MSFT

Price per share = $98.39

Earnings per share = $1.49

∴ Price-Earnings Ratio = $98.39 ÷ $1.49 = 66.1x

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 MSFT, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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 MSFT’s P/E of 66.1x is higher than its industry peers (38x), it means that investors are paying more than they should for each dollar of MSFT’s earnings. As such, our analysis shows that MSFT represents an over-priced stock.

A few caveats

However, before you rush out to sell your MSFT shares, it is important to note that this conclusion is based on two key assumptions. 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 inadvertently compared riskier firms with MSFT, then investors would naturally value MSFT at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with MSFT, investors would also value MSFT at a higher price since it is a higher growth investment. Both scenarios would explain why MSFT has a higher P/E ratio than its peers. 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.

NasdaqGS:MSFT Future Profit June 27th 18

What this means for you:

Since you may have already conducted your due diligence on MSFT, the overvaluation of the stock may mean it is a good time to reduce 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:

1. 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.
2. 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.
3. 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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Noted activist shareholder, Carl Ichan has become famous (and rich) by taking positions in badly run public corporations and forcing them to make radical changes to uncover shareholders value. "Icahn lift" is a bump in a company's stock price that often occurs after he has taken a position in it. What were his last buys? Click here to view a FREE detailed infographic analysis of Carl Icahn’s investment portfolio.

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