United Microelectronics Corp (NYSE: UMC) shares currently trade at 23.9x trailing earnings which is lower than the Information Technology sector median of 30.3x. While this makes UMC look like a stock to add to your portfolio, equity investors might change their mind after taking a closer look at the assumptions behind the P/E ratio. In this article, I define how to calculate a P/E multiple and what to keep an eye out for when applying it in a comparable companies analysis.
UMC Comparable Companies Analysis
A comparable companies analysis, also known as a multiples valuation, determines the value of a subject company by benchmarking its financial performance against similar public companies or peers. We can conclude if a company looks undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation ratios.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare UMC’s P/E ratio to its peer group that includes Advanced Semiconductor Engineering, Inc. (NYSE: ASX), Semiconductor Manufacturing International Corporation (NYSE: SMI), Taiwan Semiconductor Manufacturing Company Ltd. (NYSE: TSM) and Siliconware Precision Industries Company, Ltd. (NASDAQ: SPIL).
Since UMC’s P/E of 23.9x is higher than the median of its peers (19.3x), it means that investors are paying more than they should for each dollar of UMC’s earnings. As such, our analysis shows that UMC represents an overvalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of $2.19 per share which implies -16.0% downside.
I selected a fair multiple of 20.1x in my analysis by averaging UMC’s current P/E ratio with its peer group.
Are Peers Really Comparable?
Before concluding that UMC should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to UMC, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare UMC with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
However, if the second assumption does not hold true, UMC’s higher multiple may be because firms in our peer group are being undervalued by the market.
How This Impacts Shareholders
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to UMC. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on UMC by taking a look at the following:
Valuation Metrics: what is UMC’s free cash flow yield and how does it compare to its publicly traded peers? This metric measures the amount of free cash flow for each dollar of equity (market capitalization). Analyze the free cash flow yield here.
Risk Metrics: what is UMC’s cash ratio which is used to assess a company’s short-term liquidity. View the company’s cash ratio here.
Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View UMC’s return on equity here.
Author: Matt Hogan
Expertise: Valuation, financial statement analysis
Matt Hogan is also a co-founder of finbox.io. His expertise is in investment decision making. Prior to finbox.io, Matt worked for an investment banking group providing fairness opinions in connection to stock acquisitions. He spent much of his time building valuation models to help clients determine an asset’s fair value. He believes that these same valuation models should be used by all investors before buying or selling a stock.
Matt can be reached at firstname.lastname@example.org.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.