Saga Communications Inc (AMEX:SGA) is currently trading at a trailing P/E of 15.7x, which is lower than the industry average of 24.1x. While SGA might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Saga Communications

Breaking down the Price-Earnings 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 SGA

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

SGA Price-Earnings Ratio = 45.2 ÷ 2.88 = 15.7x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 SGA, 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 15.7x, SGA’s P/E is lower than its industry peers (24.1x). This implies that investors are undervaluing each dollar of SGA’s earnings. Therefore, according to this analysis, SGA is an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy SGA, 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 SGA, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with SGA, 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 SGA to are fairly valued by the market. If this is violated, SGA'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 SGA, 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 SGA has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.