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Escalade Incorporated (NASDAQ:ESCA) is trading with a trailing P/E of 18.7x, which is lower than the industry average of 19.3x. 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 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 Escalade

### Breaking down the Price-Earnings ratio

The P/E ratio is one of many ratios used in 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 ESCA

Price-Earnings Ratio = Price per share ÷ Earnings per share

ESCA Price-Earnings Ratio = \$13.1 ÷ \$0.702 = 18.7x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ESCA, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since ESCA’s P/E of 18.7x is lower than its industry peers (19.3x), it means that investors are paying less than they should for each dollar of ESCA’s earnings. As such, our analysis shows that ESCA represents an under-priced stock.

### Assumptions to watch out for

While our conclusion might prompt you to buy ESCA immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ESCA, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with ESCA, 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 ESCA to are fairly valued by the market. If this does not hold, there is a possibility that ESCA’s P/E is lower because our peer group is overvalued by the market.

### What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on ESCA, 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 you are considering investing in ESCA, 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 Escalade 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.