Medistim ASA (OB:MEDI) is currently trading at a trailing P/E of 30.3x, which is lower than the industry average of 33.7x. While MEDI might seem like an attractive stock to buy, 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 Medistim
Breaking down 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 MEDI
Price-Earnings Ratio = Price per share ÷ Earnings per share
MEDI Price-Earnings Ratio = NOK79.4 ÷ NOK2.62 = 30.3x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to MEDI, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since MEDI’s P/E of 30.3x is lower than its industry peers (33.7x), it means that investors are paying less than they should for each dollar of MEDI’s earnings. Therefore, according to this analysis, MEDI is an under-priced stock.
A few caveats
Before you jump to the conclusion that MEDI is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to MEDI, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with MEDI, 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 MEDI to are fairly valued by the market. If this is violated, MEDI’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to MEDI. 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: