Sabine Royalty Trust (NYSE:SBR) is trading with a trailing P/E of 21.2x, which is higher than the industry average of 15.1x. While SBR might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Sabine Royalty 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. 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 SBR
Price per share = $48.15
Earnings per share = $2.274
∴ Price-Earnings Ratio = $48.15 ÷ $2.274 = 21.2x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SBR, such as size and country of operation. 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 21.2x, SBR’s P/E is higher than its industry peers (15.1x). This implies that investors are overvaluing each dollar of SBR’s earnings. Therefore, according to this analysis, SBR is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your SBR shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to SBR. 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 riskier firms with SBR, then SBR’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with SBR. In this case, SBR’s P/E would be higher since investors would also reward SBR’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing SBR to are fairly valued by the market. If this does not hold, there is a possibility that SBR’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:Since you may have already conducted your due diligence on SBR, the overvaluation of the stock may mean it is a good time to reduce 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:
1. Financial Health: Is SBR’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.
2. Past Track Record: Has SBR been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of SBR’s historicals for more clarity.
3. 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.