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Masimo Corporation (NASDAQ:MASI) trades with a trailing P/E of 35.7x, which is higher than the industry average of 33.8x. While this makes MASI appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Masimo
Breaking down the Price-Earnings 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.
P/E Calculation for MASI
Price-Earnings Ratio = Price per share ÷ Earnings per share
MASI Price-Earnings Ratio = $91.13 ÷ $2.555 = 35.7x
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 MASI, 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. MASI’s P/E of 35.7x is higher than its industry peers (33.8x), which implies that each dollar of MASI’s earnings is being overvalued by investors. As such, our analysis shows that MASI represents an over-priced stock.
A few caveats
However, before you rush out to sell your MASI 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 MASI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with MASI, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing MASI to are fairly valued by the market. If this is violated, MASI’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in MASI. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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: