IDT Corporation (NYSE:IDT) is trading with a trailing P/E of 11.1x, which is lower than the industry average of 18.4x. While this makes IDT appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for IDT

Breaking down the Price-Earnings ratio

The P/E ratio is one of many ratios used in 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 IDT

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

IDT Price-Earnings Ratio = 14.08 ÷ 1.273 = 11.1x

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 IDT, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. IDT’s P/E of 11.1x is lower than its industry peers (18.4x), which implies that each dollar of IDT’s earnings is being undervalued by investors. Therefore, according to this analysis, IDT is an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy IDT immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to IDT, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with IDT, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing IDT to are fairly valued by the market. If this does not hold true, IDT’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

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 IDT 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 you are considering investing in IDT, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.

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 IDT 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.