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Dominion Energy Midstream Partners LP (NYSE:DM) is trading with a trailing P/E of 10.2x, which is lower than the industry average of 14.4x. While DM might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Dominion Energy Midstream Partners
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
P/E Calculation for DM
Price-Earnings Ratio = Price per share ÷ Earnings per share
DM Price-Earnings Ratio = $14.5 ÷ $1.426 = 10.2x
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 DM, 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 DM’s P/E of 10.2x is lower than its industry peers (14.4x), it means that investors are paying less than they should for each dollar of DM’s earnings. Therefore, according to this analysis, DM is an under-priced stock.
A few caveats
However, before you rush out to buy DM, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to DM, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with DM, 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 DM to are fairly valued by the market. If this does not hold, there is a possibility that DM’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
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 DM 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. 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 highly recommend you to complete your research by taking a look at the following: