San Juan Basin Royalty Trust (NYSE:SJT) is trading with a trailing P/E of 10.7x, which is lower than the industry average of 15.1x. While this makes SJT 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for San Juan Basin Royalty Trust
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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 SJT
Price per share = $8.43
Earnings per share = $0.786
∴ Price-Earnings Ratio = $8.43 ÷ $0.786 = 10.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SJT, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.
SJT’s P/E of 10.7x is lower than its industry peers (15.1x), which implies that each dollar of SJT’s earnings is being undervalued by investors. As such, our analysis shows that SJT represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy SJT immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SJT. 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 SJT, then investors would naturally value SJT at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SJT, investors would also value SJT at a lower price since it is a lower growth investment. Both scenarios would explain why SJT has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SJT to are fairly valued by the market. If this does not hold, there is a possibility that SJT’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to SJT. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 SJT’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 SJT 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 SJT’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.