Resources Connection Inc (NASDAQ:RECN) is currently trading at a trailing P/E of 24.1x, which is lower than the industry average of 24.9x. While this makes RECN 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 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 Resources Connection

What you need to know about the P/E ratio

P/E is a popular ratio used for 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 RECN

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

RECN Price-Earnings Ratio = 13.7 ÷ 0.568 = 24.1x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to RECN, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since RECN's P/E of 24.1x is lower than its industry peers (24.9x), it means that investors are paying less than they should for each dollar of RECN's earnings. Therefore, according to this analysis, RECN is an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy RECN, 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 RECN, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with RECN, 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 RECN to are fairly valued by the market. If this does not hold, there is a possibility that RECN’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on RECN, 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 RECN, 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.