Darden Restaurants Inc (NYSE:DRI) is currently trading at a trailing P/E of 24.6x, which is lower than the industry average of 25x. While this makes DRI 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. See our latest analysis for Darden Restaurants
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 DRI
Price-Earnings Ratio = Price per share ÷ Earnings per share
DRI Price-Earnings Ratio = $99.04 ÷ $4.029 = 24.6x
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 DRI, 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. At 24.6x, DRI’s P/E is lower than its industry peers (25x). This implies that investors are undervaluing each dollar of DRI’s earnings. Therefore, according to this analysis, DRI is an under-priced stock.
A few caveats
However, before you rush out to buy DRI, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to DRI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with DRI, 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 DRI to are fairly valued by the market. If this does not hold, there is a possibility that DRI’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? 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 DRI 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.
Are you a potential investor? If DRI has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.