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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Bayer Aktiengesellschaft (FRA:BAYN) is currently trading at a trailing P/E of 20.5x, which is higher than the industry average of 20.5x. While BAYN 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. 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.
Check out our latest analysis for Bayer
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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 BAYN
Price-Earnings Ratio = Price per share ÷ Earnings per share
BAYN Price-Earnings Ratio = €82.11 ÷ €3.996 = 20.5x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to BAYN, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 20.5x, BAYN’s P/E is higher than its industry peers (20.5x). This implies that investors are overvaluing each dollar of BAYN’s earnings. This multiple is a median of profitable companies of 25 Pharmaceuticals companies in DE including Mallinckrodt, Lansen Pharmaceutical Holdings and Lannett Company. As such, our analysis shows that BAYN represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your BAYN shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to BAYN. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with BAYN, 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 BAYN to are fairly valued by the market. If this does not hold, there is a possibility that BAYN’s P/E is lower because our peer group is overvalued by the market.