Hugoton Royalty Trust (NYSE:HGT) is currently trading at a trailing P/E of 9.5x, which is lower than the industry average of 13.9x. While this makes HGT 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 Hugoton Royalty Trust
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 HGT
Price-Earnings Ratio = Price per share ÷ Earnings per share
HGT Price-Earnings Ratio = $0.71 ÷ $0.075 = 9.5x
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 HGT, 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. HGT’s P/E of 9.5x is lower than its industry peers (13.9x), which implies that each dollar of HGT’s earnings is being undervalued by investors. Therefore, according to this analysis, HGT is an under-priced stock.
A few caveats
However, before you rush out to buy HGT, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to HGT. 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 HGT, 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 HGT to are fairly valued by the market. If this is violated, HGT’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on HGT, 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. 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Is HGT’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 HGT 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 HGT’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.