NL Industries Inc (NYSE:NL) is trading with a trailing P/E of 10.3x, which is lower than the industry average of 26.1x. While this makes NL 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. See our latest analysis for NL

What you need to know about the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 NL

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

NL Price-Earnings Ratio = 14 ÷ 1.365 = 10.3x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as NL, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since NL’s P/E of 10.3x is lower than its industry peers (26.1x), it means that investors are paying less than they should for each dollar of NL’s earnings. As such, our analysis shows that NL represents an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy NL immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to NL, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with NL, 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 NL to are fairly valued by the market. If this is violated, NL’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? Since you may have already conducted your due diligence on NL, 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 NL, 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.

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 NL Industries 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.