SpartanNash Company (NASDAQ:SPTN) trades with a trailing P/E of 15.3x, which is lower than the industry average of 20.3x. While this makes SPTN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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 SpartanNash

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for 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 SPTN

Price per share = 26.68

Earnings per share = 1.746

∴ Price-Earnings Ratio = 26.68 ÷ 1.746 = 15.3x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SPTN, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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.

At 15.3x, SPTN’s P/E is lower than its industry peers (20.3x). This implies that investors are undervaluing each dollar of SPTN’s earnings. Therefore, according to this analysis, SPTN is an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy SPTN immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SPTN. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with SPTN, then SPTN’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 SPTN. In this case, SPTN’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 SPTN to are fairly valued by the market. If this assumption does not hold true, SPTN’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.