Brinker International Inc (NYSE:EAT) is trading with a trailing P/E of 10.3x, which is lower than the industry average of 29.6x. While EAT might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Brinker International
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for EAT
Price per share = 30.55
Earnings per share = 2.978
∴ Price-Earnings Ratio = 30.55 ÷ 2.978 = 10.3x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to EAT, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since EAT's P/E of 10.3x is lower than its industry peers (29.6x), it means that investors are paying less than they should for each dollar of EAT's earnings. As such, our analysis shows that EAT represents an under-priced stock.
A few caveats
However, before you rush out to buy EAT, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to EAT. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with EAT, then investors would naturally value EAT at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with EAT, investors would also value EAT at a lower price since it is a lower growth investment. Both scenarios would explain why EAT has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing EAT to are fairly valued by the market. If this assumption is violated, EAT's P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on EAT, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If you are considering investing in EAT, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Brinker International for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.