Pfizer Inc (NYSE:PFE) trades with a trailing P/E of 25.7x, which is lower than the industry average of 27.5x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for PFE

Breaking down 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.

Formula

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

P/E Calculation for PFE

Price per share = 35.45

Earnings per share = 1.379

∴ Price-Earnings Ratio = 35.45 ÷ 1.379 = 25.7x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to PFE, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.

PFE’s P/E of 25.7x is lower than its industry peers (27.5x), which implies that each dollar of PFE’s earnings is being undervalued by investors. Therefore, according to this analysis, PFE is an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy PFE, 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 PFE. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with PFE, then investors would naturally value PFE at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with PFE, investors would also value PFE at a lower price since it is a lower growth investment. Both scenarios would explain why PFE has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing PFE to are fairly valued by the market. If this assumption does not hold true, PFE’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.