FMC Corporation (NYSE:FMC) is currently trading at a trailing P/E of 44.8x, which is higher than the industry average of 21.1x. While FMC 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for FMC
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.
P/E Calculation for FMC
Price-Earnings Ratio = Price per share ÷ Earnings per share
FMC Price-Earnings Ratio = $95.46 ÷ $2.129 = 44.8x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to FMC, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 44.8x, FMC’s P/E is higher than its industry peers (21.1x). This implies that investors are overvaluing each dollar of FMC’s earnings. As such, our analysis shows that FMC represents an over-priced stock.
A few caveats
Before you jump to the conclusion that FMC 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 FMC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with FMC, 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 FMC to are fairly valued by the market. If this does not hold, there is a possibility that FMC’s P/E is lower because our peer group is overvalued by the market.
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 FMC. 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.