Bridgford Foods Corporation (NASDAQ:BRID) is trading with a trailing P/E of 31.1x, which is higher than the industry average of 19.1x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Bridgford Foods

Demystifying the P/E ratio

P/E is a popular ratio used for 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 BRID

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

BRID Price-Earnings Ratio = $16.2 ÷ $0.521 = 31.1x

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 BRID, 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 BRID’s P/E of 31.1x is higher than its industry peers (19.1x), it means that investors are paying more than they should for each dollar of BRID’s earnings. Therefore, according to this analysis, BRID is an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your BRID shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to BRID, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with BRID, 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 BRID to are fairly valued by the market. If this does not hold true, BRID’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.