Sandridge Mississippian Trust II (NYSE:SDR) is trading with a trailing P/E of 5.4x, which is lower than the industry average of 32.6x. While this makes SDR 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for SDR
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. 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 SDR
Price per share = 1.32
Earnings per share = 0.242
∴ Price-Earnings Ratio = 1.32 ÷ 0.242 = 5.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 SDR, 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.
SDR’s P/E of 5.4x is lower than its industry peers (32.6x), which implies that each dollar of SDR’s earnings is being undervalued by investors. Therefore, according to this analysis, SDR is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that SDR represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to SDR. 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 SDR, then investors would naturally value SDR at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SDR, investors would also value SDR at a lower price since it is a lower growth investment. Both scenarios would explain why SDR has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SDR to are fairly valued by the market. If this does not hold, there is a possibility that SDR’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to SDR. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in SDR, 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 Sandridge Mississippian Trust II 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.