SandRidge Permian Trust (NYSE:PER) is currently trading at a trailing P/E of 6x, which is lower than the industry average of 20.8x. While this makes PER 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 explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for SandRidge Permian Trust

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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.

P/E Calculation for PER

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

PER Price-Earnings Ratio = 2.8 ÷ 0.465 = 6x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to PER, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 6x, PER’s P/E is lower than its industry peers (20.8x). This implies that investors are undervaluing each dollar of PER’s earnings. As such, our analysis shows that PER represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy PER, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to PER. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with PER, 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 PER to are fairly valued by the market. If this does not hold true, PER’s lower P/E ratio may be because firms in our peer group are 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 PER 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 PER, 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.