Journey Energy Inc (TSX:JOY) is trading with a trailing P/E of 1.5x, which is lower than the industry average of 17x. 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Journey Energy

Breaking down the Price-Earnings 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.

P/E Calculation for JOY

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

JOY Price-Earnings Ratio = CA$1.72 ÷ CA$1.16 = 1.5x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to JOY, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. JOY’s P/E of 1.5x is lower than its industry peers (17x), which implies that each dollar of JOY’s earnings is being undervalued by investors. Therefore, according to this analysis, JOY is an under-priced stock.

A few caveats

However, before you rush out to buy JOY, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to JOY. 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 JOY, 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 JOY to are fairly valued by the market. If this is violated, JOY’s P/E may be lower than its peers as they are actually overvalued by investors.

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 JOY. 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.

Are you a potential investor? If JOY 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.