STMicroelectronics NV (NYSE:STM) is currently trading at a trailing P/E of 40x, which is higher than the industry average of 25.8x. While this makes STM 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 STMicroelectronics N.V
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for STM
Price-Earnings Ratio = Price per share ÷ Earnings per share
STM Price-Earnings Ratio = 20.02 ÷ 0.499 = 40x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to STM, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 40x, STM’s P/E is higher than its industry peers (25.8x). This implies that investors are overvaluing each dollar of STM’s earnings. Therefore, according to this analysis, STM is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that STM should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to STM, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with STM, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing STM to are fairly valued by the market. If this is violated, STM's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 STM. 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.
Are you a potential investor? If you are considering investing in STM, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.