SandRidge Mississippian Trust II (NYSE:SDR) is trading with a trailing P/E of 4.7x, which is lower than the industry average of 14.1x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for SandRidge Mississippian Trust II
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.
P/E Calculation for SDR
Price-Earnings Ratio = Price per share ÷ Earnings per share
SDR Price-Earnings Ratio = $1.07 ÷ $0.229 = 4.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SDR, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 4.7x, SDR’s P/E is lower than its industry peers (14.1x). This implies that investors are undervaluing each dollar of SDR’s earnings. Therefore, according to this analysis, SDR is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that SDR is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to SDR, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SDR, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing SDR to are fairly valued by the market. If this is violated, SDR’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of SDR to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
Financial Health: Is SDR’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
Past Track Record: Has SDR been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of SDR’s historicals for more clarity.
Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
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.