In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Oil and Natural Gas Corporation Limited (NSE:ONGC) trades with a trailing P/E of 8.5x, which is lower than the industry average of 11x. While this makes ONGC 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
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Breaking down 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 ONGC
Price-Earnings Ratio = Price per share ÷ Earnings per share
ONGC Price-Earnings Ratio = ₹147.05 ÷ ₹17.226 = 8.5x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 ONGC, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since ONGC’s P/E of 8.5 is lower than its industry peers (11), it means that investors are paying less for each dollar of ONGC’s earnings. This multiple is a median of profitable companies of 18 Oil and Gas companies in IN including Hindustan Petroleum, Chennai Petroleum and Indian Oil. You can think of it like this: the market is suggesting that ONGC is a weaker business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to ONGC, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with ONGC, 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 ONGC to are fairly valued by the market. If this is violated, ONGC’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
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 ONGC. 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. 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 urge you to complete your research by taking a look at the following: