Oracle Corporation (NYSE:ORCL) trades with a trailing P/E of 21.4x, which is lower than the industry average of 31.9x. While this makes ORCL 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 Oracle

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.

P/E Calculation for ORCL

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

ORCL Price-Earnings Ratio = $50.39 ÷ $2.355 = 21.4x

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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ORCL, 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 ORCL’s P/E of 21.4x is lower than its industry peers (31.9x), it means that investors are paying less than they should for each dollar of ORCL’s earnings. Therefore, according to this analysis, ORCL is an under-priced stock.

A few caveats

However, before you rush out to buy ORCL, 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 ORCL, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with ORCL, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ORCL to are fairly valued by the market. If this does not hold, there is a possibility that ORCL’s P/E is lower because our peer group is overvalued by the market.

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 ORCL 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 ORCL, 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.