SandRidge Permian Trust (NYSE:PER) trades with a trailing P/E of 4.3x, which is lower than the industry average of 12.7x. While this makes PER 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. See our latest analysis for SandRidge Permian Trust
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
P/E Calculation for PER
Price-Earnings Ratio = Price per share ÷ Earnings per share
PER Price-Earnings Ratio = $2 ÷ $0.464 = 4.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to PER, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 4.3x, PER’s P/E is lower than its industry peers (12.7x). This implies that investors are undervaluing each dollar of PER’s earnings. As such, our analysis shows that PER represents an under-priced stock.
A few caveats
However, before you rush out to buy PER, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to PER. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with PER, 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 PER to are fairly valued by the market. If this does not hold true, PER’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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.