SandRidge Mississippian Trust I (NYSE:SDT) is currently trading at a trailing P/E of 4.7x, which is lower than the industry average of 13.4x. While this makes SDT 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for SandRidge Mississippian Trust I
What you need to know about 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 = $1.03 ÷ $0.218 = 4.7x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 SDT, 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. SDT’s P/E of 4.7x is lower than its industry peers (13.4x), which implies that each dollar of SDT’s earnings is being undervalued by investors. 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. Firstly, our peer group contains companies that are similar to SDT. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with SDT, 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 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:
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 SDT. 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- Financial Health: Is SDT’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has SDT been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of SDT’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
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.