One metric that many investors like to look at to judge the value that a company's stock offers is the price-to-earnings ratio, which is calculated by dividing the company's share price by its earnings per share (EPS).
By this metric, memory specialist Micron (MU +5.08%) is comically cheap, trading at a P/E of just 3.51. Put another way, this means that if Micron were to continue to earn what it had over the last 12 months, it would bring in profit equal to the company's value in just three and a half years.
Image source: Micron.
While the trailing-12-month P/E ratio is a useful metric, it's also important for investors to understand that when that figure looks unreasonably cheap, there's probably something else at play. And, with Micron, there is.
Micron's earnings are set to tumble
The reason that Micron's current price-to-earnings ratio is so low is simple: In the near term, investors don't expect the company to bring in as much net income as it has over the last 12 months.
Indeed, according to analyst estimates, the company is set to see its EPS fall to $7.68 from $11.95 in the prior year -- a nearly 36% decline. That drop is set to happen due to industrywide oversupply of both DRAM -- Micron's biggest revenue and profit driver -- as well as NAND flash memory.
Remember that both DRAM and NAND are commodities, so the prices that Micron (and other memory makers) can ultimately charge are dependent on industrywide supply and demand for those chips. When supply exceeds demand, prices fall, and when demand exceeds supply, prices rise (as they had for a while before the recent declines).
According to DRAMeXchange, DRAM prices are set to drop by about 20% in the first quarter of 2019 followed by another 15% plunge in the second quarter, which works out to a 32% decline over those two quarters. After that, DRAMeXchange says, "[T]he price downswing will moderate over the next several quarters."
Indeed, analysts are calling for Micron's EPS to fall further to $6.53 in 2020 on roughly flat revenue.
Check out the latest Micron earnings call transcript.
Is Micron still cheap?
As of this writing, Micron stock trades at $42.57 -- up significantly from the 52-week low of $28.29 that it set back in late December 2018, but still down 34% from its 52-week high. At this point, it's clear that investors have had time to digest the reality that the memory pricing environment is probably going to be rough for a while.
The good news, though, is that Micron stock still looks pretty cheap relative to analysts' projected 2020 EPS, trading at just 6.52 times that projection. But it's still nowhere as cheap as what the trailing-12-month P/E ratio would suggest.
Now, fair warning -- if DRAM and NAND prices fall more aggressively than analysts expect, or if the declines persist for longer than some forecast, then that $6.53 EPS estimate for 2020 might prove too high, or that estimate might be dead on, but it'd be followed by further declines in 2021.
Investor takeaway
The memory market routinely takes investors on wild rides. It was only a few years ago that Micron's gross margin percentage was in the low 20s and its free cash flow was significantly negative. The memory market taking a sharp upward turn, coupled with some product and technology execution improvements on Micron's side, led the company's gross margin and free cash flow to swell in rather short order.
MU Gross Profit Margin (TTM) data by YCharts.
Now the memory market is on the decline and Micron's stock price and forward estimates seem to reflect that. If what Micron CEO Sanjay Mehrotra said on the company's most recent earnings call -- that the "memory industry is structurally stronger, with more diversified demand drivers and moderating supply growth capability" -- is correct, then Micron's business should ultimately continue to be significantly profitable even at the end of this memory industry correction.
