ECA Marcellus Trust I (NYSE:ECT) is currently trading at a trailing P/E of 6.8x, which is lower than the industry average of 15.2x. While this makes ECT 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 ECA Marcellus Trust I
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 ECT
Price-Earnings Ratio = Price per share ÷ Earnings per share
ECT Price-Earnings Ratio = $2.25 ÷ $0.332 = 6.8x
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 ECT, 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 ECT’s P/E of 6.8x is lower than its industry peers (15.2x), it means that investors are paying less than they should for each dollar of ECT’s earnings. As such, our analysis shows that ECT represents an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy ECT, 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 ECT, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with ECT, 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 ECT to are fairly valued by the market. If this does not hold true, ECT’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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.