Emerson Electric Co (NYSE:EMR) is trading with a trailing P/E of 28.2x, which is higher than the industry average of 20.3x. While this makes EMR 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Emerson Electric
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 EMR
Price-Earnings Ratio = Price per share ÷ Earnings per share
EMR Price-Earnings Ratio = $72.2 ÷ $2.559 = 28.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 EMR, 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 EMR’s P/E of 28.2x is higher than its industry peers (20.3x), it means that investors are paying more than they should for each dollar of EMR’s earnings. As such, our analysis shows that EMR represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that EMR should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to EMR. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with EMR, 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 EMR to are fairly valued by the market. If this is violated, EMR’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 EMR. 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.