Pacific Energy Limited (ASX:PEA) trades with a trailing P/E of 13x, which is higher than the industry average of 12.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Pacific Energy
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 PEA
Price-Earnings Ratio = Price per share ÷ Earnings per share
PEA Price-Earnings Ratio = 0.58 ÷ 0.045 = 13x
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 PEA, 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 13x, PEA’s P/E is higher than its industry peers (12.3x). This implies that investors are overvaluing each dollar of PEA’s earnings. As such, our analysis shows that PEA represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your PEA shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to PEA, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with PEA, 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 PEA to are fairly valued by the market. If this does not hold true, PEA’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? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to PEA. 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.