Enduro Royalty Trust (NYSE:NDRO) is trading with a trailing P/E of 2.5x, which is lower than the industry average of 12.9x. While NDRO 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. Today, 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 Enduro Royalty Trust

Breaking down the Price-Earnings 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 NDRO

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

NDRO Price-Earnings Ratio = $3.4 ÷ $1.356 = 2.5x

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 NDRO, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. NDRO’s P/E of 2.5x is lower than its industry peers (12.9x), which implies that each dollar of NDRO’s earnings is being undervalued by investors. Therefore, according to this analysis, NDRO is an under-priced stock.

A few caveats

However, before you rush out to buy NDRO, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to NDRO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with NDRO, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing NDRO to are fairly valued by the market. If this does not hold, there is a possibility that NDRO’s P/E is lower because our peer group is 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.