W R Berkley Corporation (NYSE:WRB) is trading with a trailing P/E of 15.6x, which is lower than the industry average of 17.8x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for W. R. Berkley

Demystifying the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 WRB

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

WRB Price-Earnings Ratio = 68.67 ÷ 4.416 = 15.6x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as WRB, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 15.6x, WRB’s P/E is lower than its industry peers (17.8x). This implies that investors are undervaluing each dollar of WRB’s earnings. As such, our analysis shows that WRB represents an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy WRB immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to WRB, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with WRB, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing WRB to are fairly valued by the market. If this does not hold, there is a possibility that WRB’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? 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 WRB. 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.