BP Prudhoe Bay Royalty Trust (NYSE:BPT) is trading with a trailing P/E of 5.5x, which is lower than the industry average of 20.8x. While BPT 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 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 BP Prudhoe Bay Royalty Trust

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 BPT

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

BPT Price-Earnings Ratio = 18.95 ÷ 3.457 = 5.5x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to BPT, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since BPT’s P/E of 5.5x is lower than its industry peers (20.8x), it means that investors are paying less than they should for each dollar of BPT’s earnings. Therefore, according to this analysis, BPT is an under-priced stock.

A few caveats

However, before you rush out to buy BPT, 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 BPT, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with BPT, 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 BPT to are fairly valued by the market. If this is violated, BPT’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 BPT, 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 BPT, 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.