Manning & Napier Inc (NYSE:MN) is currently trading at a trailing P/E of 7.1x, which is lower than the industry average of 21x. While MN 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 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 Manning & Napier

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in 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.

Formula

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

P/E Calculation for MN

Price per share = 3.75

Earnings per share = 0.527

∴ Price-Earnings Ratio = 3.75 ÷ 0.527 = 7.1x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to MN, 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. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 7.1x, MN’s P/E is lower than its industry peers (21x). This implies that investors are undervaluing each dollar of MN’s earnings. Therefore, according to this analysis, MN is an under-priced stock.

A few caveats

Before you jump to the conclusion that MN represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to MN. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with MN, then MN’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with MN, MN’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing MN to are fairly valued by the market. If this assumption does not hold true, MN’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.