Network-1 Technologies Inc (AMEX:NTIP) is trading with a trailing P/E of 5.8x, which is lower than the industry average of 26.4x. While this makes NTIP 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. View our latest analysis for Network-1 Technologies

Breaking down the Price-Earnings 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.

Formula

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

P/E Calculation for NTIP

Price per share = 3.65

Earnings per share = 0.63

∴ Price-Earnings Ratio = 3.65 ÷ 0.63 = 5.8x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to NTIP, 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 it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.

Since NTIP's P/E of 5.8x is lower than its industry peers (26.4x), it means that investors are paying less than they should for each dollar of NTIP's earnings. Therefore, according to this analysis, NTIP is an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy NTIP immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to NTIP. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing lower risk firms with NTIP, then NTIP’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with NTIP. In this case, NTIP’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing NTIP to are fairly valued by the market. If this assumption is violated, NTIP's P/E may be lower than its peers because its peers are actually overvalued by investors.

What this means for you:

Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of NTIP to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.

Are you a potential investor? If you are considering investing in NTIP, 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.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Network-1 Technologies for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.