Sandridge Mississippian Trust II (NYSE:SDR) is currently trading at a trailing P/E of 5.1x, which is lower than the industry average of 14.8x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Sandridge Mississippian Trust II
What you need to know about the P/E ratio
P/E is a popular ratio used for 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 SDR
Price-Earnings Ratio = Price per share ÷ Earnings per share
SDR Price-Earnings Ratio = $1.06 ÷ $0.206 = 5.1x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SDR, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since SDR’s P/E of 5.1x is lower than its industry peers (14.8x), it means that investors are paying less than they should for each dollar of SDR’s earnings. As such, our analysis shows that SDR represents an under-priced stock.
A few caveats
However, before you rush out to buy SDR, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to SDR. 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 SDR, 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 SDR to are fairly valued by the market. If this is violated, SDR’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.