The Southern Company (NYSE:SO) trades with a trailing P/E of 52.9x, which is higher than the industry average of 14.1x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Southern

Demystifying 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 SO

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

SO Price-Earnings Ratio = $44.53 ÷ $0.842 = 52.9x

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 SO, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 52.9x, SO’s P/E is higher than its industry peers (14.1x). This implies that investors are overvaluing each dollar of SO’s earnings. As such, our analysis shows that SO represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your SO shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SO, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SO, 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 SO to are fairly valued by the market. If this does not hold true, SO’s lower P/E ratio may be because firms in our peer group are 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.