Explainer: Why Micron Looks Cheaper Than It Actually Is Right Now

Micron Technology (NASDAQ: MU) is one of the hottest stocks in the market right now. Massive demand for its memory chips has driven prices higher over the last year, leading to record-breaking earnings for the company. Still, the stock trades for just 13.6 times analysts' earnings expectations for the next 12 months. For comparison, the S&P 500 trades for close to 22 times forecast earnings.

Many investors have pointed out how cheap Micron appears to be at its current price. In fact, Micron's the largest position in the Vanguard Value ETF, suggesting the stock is undervalued right now. But the truth is Micron's not as cheap as it looks. Here's why.

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Looking beyond the current price-to-earnings ratio

It's true that Micron trades for low price relative to its earnings expectations over the next 12 months. And analysts expect Micron's earnings to grow even more over the next two years, projecting Micron will generate over $160 in earnings per share by fiscal 2028, making its price around $1,000 per share look like an incredible bargain.

But the semiconductor industry is cyclical, and few segments are more so than memory chipmakers. That's because memory chips are commodity-like; device makers and chip packagers can, for the most part, swap out a Micron chip with any of its competitors'. That means if one of Micron's competitors increases the capacity of its chip production facilities, it will negatively impact Micron's ability to charge a premium price.

That's exactly what's playing out. Not only is Micron building out new chip manufacturing capacity, but its competitors are as well. As the pendulum of supply and demand swings the other way, Micron will see unit volume increase while pricing declines. At some point, unit volume growth won't be enough to offset price declines, and, combined with the added costs of running new facilities, profits will decline. That's the nature of cyclical stocks.

So, as Micron approaches the peak of an earnings cycle, its P/E ratio will decline. Investors shouldn't be willing to pay as much for Micron's earnings at the peak of the cycle if the expectation is for earnings to decline for the next few years. And because of the commodity-like nature of Micron's products, the decline can be severe, especially if Micron doesn't build as much capacity as its competitors. That puts it in a prisoner's dilemma where it must spend the money to build new facilities.

Micron has historically traded at a P/E ratio in the mid single digits at its earnings peaks. At nearly 14 times earnings, the market suggests there are still a few more years of earnings growth for Micron in the current cycle; analysts are currently underestimating the peak of its earnings, or that the next down cycle won't be as bad as previous ones. All indications from Micron and its competitors suggest that the supply shortage will start to abate by 2028, which should have a noticeable negative impact on earnings in 2029 and 2030. Expectations for Micron are already sky-high, and the market is increasingly valuing it as if its earnings will never come down again. Don't confuse a highly cyclical stock with a value.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Micron Technology and Vanguard Value ETF. The Motley Fool has a disclosure policy.