Dorchester Minerals LP (NASDAQ:DMLP) is currently trading at a trailing P/E of 14.9x, which is lower than the industry average of 31.4x. While this makes DMLP appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Dorchester Minerals
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as 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 DMLP
Price per share = 14.3
Earnings per share = 0.958
∴ Price-Earnings Ratio = 14.3 ÷ 0.958 = 14.9x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to DMLP, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
DMLP’s P/E of 14.9x is lower than its industry peers (31.4x), which implies that each dollar of DMLP’s earnings is being undervalued by investors. Therefore, according to this analysis, DMLP is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy DMLP, 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 DMLP. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with DMLP, then DMLP’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with DMLP. In this case, DMLP’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DMLP to are fairly valued by the market. If this assumption does not hold true, DMLP’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on DMLP, 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 DMLP, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
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 Dorchester Minerals 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.