The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Smart Sand Inc (NASDAQ:SND) is trading with a trailing P/E of 10.9x, which is lower than the industry average of 19.9x. While this makes SND 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SND
Price per share = $5.8
Earnings per share = $0.533
∴ Price-Earnings Ratio = $5.8 ÷ $0.533 = 10.9x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SND, such as capital structure and profitability. 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.
At 10.9x, SND’s P/E is lower than its industry peers (19.9x). This implies that investors are undervaluing each dollar of SND’s earnings. This multiple is a median of profitable companies of 24 Energy Services companies in US including Poseidon Concepts, Tristar Acquisition Group and Covia Holdings. As such, our analysis shows that SND represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that SND represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to SND. 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 SND, then SND’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 SND. In this case, SND’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 SND to are fairly valued by the market. If this assumption is violated, SND’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on SND, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SND’s future growth? Take a look at our free research report of analyst consensus for SND’s outlook.
- Financial Health: Is SND’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.