The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Cue Energy Resources Limited (ASX:CUE) is trading with a trailing P/E of 5.7x, which is lower than the industry average of 16.3x. While this makes CUE appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Check out our latest analysis for Cue Energy Resources
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 CUE
Price-Earnings Ratio = Price per share ÷ Earnings per share
CUE Price-Earnings Ratio = A$0.063 ÷ A$0.0111 = 5.7x
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 CUE, 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 5.7, CUE’s P/E is lower than its industry peers (16.3). This implies that investors are undervaluing each dollar of CUE’s earnings. This multiple is a median of profitable companies of 24 Oil and Gas companies in AU including Paladin Energy, New Age Exploration and Moreton Resources. One could put it like this: the market is pricing CUE as if it is a weaker company than the average company in its industry.
A few caveats
However, 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 CUE, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CUE, 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 CUE to are fairly valued by the market. If this does not hold, there is a possibility that CUE’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on CUE, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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: