Macquarie Group Limited (ASX:MQG) is trading with a trailing P/E of 13.6x, which is lower than the industry average of 22.2x. 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. Today, 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 MQG
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 MQG
Price-Earnings Ratio = Price per share ÷ Earnings per share
MQG Price-Earnings Ratio = A$97.45 ÷ A$7.162 = 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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to MQG, 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. MQG’s P/E of 13.6x is lower than its industry peers (22.2x), which implies that each dollar of MQG’s earnings is being undervalued by investors. Therefore, according to this analysis, MQG is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy MQG immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to MQG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with MQG, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing MQG to are fairly valued by the market. If this does not hold, there is a possibility that MQG’s P/E is lower because our peer group is overvalued by the market.
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 undervaluation could signal a good buying opportunity to increase your exposure to MQG. 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.
Are you a potential investor? If you are considering investing in MQG, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.