SandRidge Mississippian Trust I (NYSE:SDT) trades with a trailing P/E of 6x, which is lower than the industry average of 20.8x. While SDT 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for SDT
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 SDT
Price-Earnings Ratio = Price per share ÷ Earnings per share
SDT Price-Earnings Ratio = 1.31 ÷ 0.22 = 6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SDT, 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 SDT's P/E of 6x is lower than its industry peers (20.8x), it means that investors are paying less than they should for each dollar of SDT's earnings. As such, our analysis shows that SDT represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy SDT immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SDT, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SDT, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing SDT to are fairly valued by the market. If this is violated, SDT's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on SDT, 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 SDT has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
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 I 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.