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 begin learning the link between Seadrill Partners LLC (NYSE:SDLP)’s fundamentals and stock market performance.
Seadrill Partners LLC (NYSE:SDLP) trades with a trailing P/E of 3.7x, which is lower than the industry average of 17.3x. While this makes SDLP 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. Check out our latest analysis for Seadrill Partners
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SDLP
Price per share = $3.28
Earnings per share = $0.884
∴ Price-Earnings Ratio = $3.28 ÷ $0.884 = 3.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SDLP, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
SDLP’s P/E of 3.7x is lower than its industry peers (17.3x), which implies that each dollar of SDLP’s earnings is being undervalued by investors. Therefore, according to this analysis, SDLP is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that SDLP represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to SDLP. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with SDLP, then investors would naturally value SDLP at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SDLP, investors would also value SDLP at a lower price since it is a lower growth investment. Both scenarios would explain why SDLP has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SDLP to are fairly valued by the market. If this does not hold, there is a possibility that SDLP’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on SDLP, 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:
- Financial Health: Is SDLP’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.
- Past Track Record: Has SDLP 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 SDLP’s historicals for more clarity.
- 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.