Micron Technology Inc (NASDAQ:MU) is trading with a trailing P/E of 13.6x, which is lower than the industry average of 34.6x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, 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 Micron Technology
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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for MU
Price per share = 32.45
Earnings per share = 2.381
∴ Price-Earnings Ratio = 32.45 ÷ 2.381 = 13.6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to MU, 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. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
Since MU's P/E of 13.6x is lower than its industry peers (34.6x), it means that investors are paying less than they should for each dollar of MU's earnings. Therefore, according to this analysis, MU is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that MU represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to MU. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with MU, then MU’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with MU, MU’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing MU to are fairly valued by the market. If this assumption does not hold true, MU’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.