Sandridge Mississippian Trust II (NYSE:SDR) is trading with a trailing P/E of 5.6x, which is lower than the industry average of 20.8x. While this makes SDR 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 SDR
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 SDR
Price-Earnings Ratio = Price per share ÷ Earnings per share
SDR Price-Earnings Ratio = 1.35 ÷ 0.242 = 5.6x
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 SDR, such as company lifetime and products sold. 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 5.6x is lower than its industry peers (20.8x), it means that investors are paying less than they should for each dollar of SDR’s earnings. Therefore, according to this analysis, SDR is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy SDR, 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 SDR, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SDR, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. 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.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of SDR to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If SDR has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
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 Sandridge Mississippian Trust II 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.