Magellan Financial Group (ASX:MFG) is currently trading at a trailing P/E of 26.3x, which is higher than the industry average of 19.2x. While MFG 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 Magellan Financial Group

Breaking down the Price-Earnings 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 MFG

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

MFG Price-Earnings Ratio = A$24.82 ÷ A$0.945 = 26.3x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to MFG, 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 26.3x, MFG’s P/E is higher than its industry peers (19.2x). This implies that investors are overvaluing each dollar of MFG’s earnings. As such, our analysis shows that MFG represents an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your MFG shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to MFG, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with MFG, 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 MFG to are fairly valued by the market. If this does not hold true, MFG’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

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.