BP Prudhoe Bay Royalty Trust (NYSE:BPT) is trading with a trailing P/E of 5.8x, which is lower than the industry average of 13.8x. While this makes BPT appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, 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 BP Prudhoe Bay Royalty Trust
What you need to know about 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 BPT
Price-Earnings Ratio = Price per share ÷ Earnings per share
BPT Price-Earnings Ratio = $20.75 ÷ $3.605 = 5.8x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BPT, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since BPT’s P/E of 5.8x is lower than its industry peers (13.8x), it means that investors are paying less than they should for each dollar of BPT’s earnings. As such, our analysis shows that BPT represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy BPT, 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 BPT, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with BPT, 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 BPT to are fairly valued by the market. If this is violated, BPT’s P/E may be lower than its peers as they are actually overvalued by investors.
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.