Masimo's price surge today seems to be confirming the bullish analyst outlook on the stock. Ending the day at $115.22, MASI has posted 3.2% gains, pushing the valuation of the stock even higher. Might the stock be overvalued, despite its buy rating?
The first step in determining whether a stock is overvalued is to check its price to book (P/B) ratio. This is perhaps the most basic measure of a company's valuation, which is its market value divided by its book value. Book value refers to the sum of all of the company's assets minus its liabilities -- you can also think of it as the company's equity value.
Traditionally, value investors would look for companies with a ratio of less than 1 (meaning that the market value was smaller than the company's book value), but such opportunities are very rare these days. So we tend to look for company's whose valuations are less than their sector and market average. The P/B ratio for Masimo is 4.77, compared to its sector average of 4.08 and the S&P 500's average P/B of 2.95.
Modernly, the most common metric for valuing a company is its Price to Earnings (P/E) ratio. It's simply today's stock price of 115.22 divided by either its trailing or forward earnings, which for Masimo are $1.63 and $3.08 respectively. Based on these values, the company's trailing P/E ratio is 70.7 and its forward P/E ratio is 37.4. By way of comparison, the average P/E ratio of the Health Care sector is 30.21 and the average P/E ratio of the S&P 500 is 15.97.
The problem with P/E ratios is that they don't take into account the growth of earnings. This means that a company with a higher than average P/E ratio may still be undervalued if it has extremely high projected earnings growth. Conversely, a company with a low P/E ratio may not present a good value proposition if its projected earnings are stagnant.
When we divide Masimo's P/E ratio by its projected 5 year earnings growth rate, we obtain its Price to Earnings Growth (PEG) ratio of 3.24. Since a PEG ratio between 0 and 1 may indicate that the company's valuation is proportionate to its growth potential, we see here that MASI is overvalued when we factor growth into the price to earnings calculus. One important caveat here is that PEG ratios are calculated on the basis of future earnings growth estimates, which may turn out to be wrong.
If a company is overvalued in terms of its earnings, we also need to check if it has the ability to meet its financial obligations. One way to check this is via the so called Quick Ratio or Acid Test, which is the sum of its current assets, inventory, and prepaid expenses divided by its current liabilities. Masimo's Quick ratio is 0.941, which indicates that that it does not have the liquidity necessary to meet its current liabilities.
Lastly, we consider Masimo's free cash flow of $-39500000. This is the sum of all of its incoming and outgoing cash flows -- including those that are unrelated to its core business, such as rent, legal costs, income from investments, debt payments, etc. A negative cash flow for a single quarter is not a particularly serious issue for a company that does not pay a dividend. But if the cash flows are negative or erratic over several years, the company may be in trouble.
Analysts are bullish on Masimo, but we are concerned they may be missing the clouded growth picture, as expressed by the stock's elevated PEG ratio. In addition, many of its valuation metrics point to a stock with an inflated value. We will keep following MASI to see whether the analyst community was right.
