Waddell & Reed Financial Inc (NYSE:WDR) is trading with a trailing P/E of 13.8x, which is lower than the industry average of 17.9x. While this makes WDR 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for WDR

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in 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 WDR

Price-Earnings Ratio = Price per share ÷ Earnings per share

WDR Price-Earnings Ratio = $19.34 ÷ $1.398 = 13.8x

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 WDR, 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. At 13.8x, WDR’s P/E is lower than its industry peers (17.9x). This implies that investors are undervaluing each dollar of WDR’s earnings. As such, our analysis shows that WDR represents an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that WDR is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to WDR, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with WDR, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing WDR to are fairly valued by the market. If this does not hold true, WDR’s lower P/E ratio may be because firms in our peer group are 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 WDR 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 WDR 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.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Waddell & Reed Financial for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.