Boston Scientific Corporation (NYSE:BSX) is trading with a trailing P/E of 50.5x, which is higher than the industry average of 42.6x. While this makes BSX 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 Boston Scientific

Breaking down the Price-Earnings 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.

P/E Calculation for BSX

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

BSX Price-Earnings Ratio = 29.17 ÷ 0.578 = 50.5x

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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BSX, 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. BSX’s P/E of 50.5x is higher than its industry peers (42.6x), which implies that each dollar of BSX’s earnings is being overvalued by investors. As such, our analysis shows that BSX represents an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your BSX 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 BSX, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with BSX, 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 BSX to are fairly valued by the market. If this does not hold true, BSX’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Are you a shareholder? 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 BSX. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.

Are you a potential investor? If you are considering investing in BSX, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Boston Scientific for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

To help readers see pass 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.