EnerJex Resources Inc (AMEX:ENRJ) trades with a trailing P/E of 1.1x, which is lower than the industry average of 20.8x. 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. Today, 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 ENRJ

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 ENRJ

Price-Earnings Ratio = Price per share ÷ Earnings per share

ENRJ Price-Earnings Ratio = 0.27 ÷ 0.254 = 1.1x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ENRJ, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 1.1x, ENRJ’s P/E is lower than its industry peers (20.8x). This implies that investors are undervaluing each dollar of ENRJ’s earnings. As such, our analysis shows that ENRJ represents an under-priced stock.

Assumptions to be aware of

Before you jump to the conclusion that ENRJ is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to ENRJ. 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 ENRJ, 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 ENRJ to are fairly valued by the market. If this does not hold, there is a possibility that ENRJ’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on ENRJ, 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.

Are you a potential investor? If you are considering investing in ENRJ, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.