APA Group (ASX:APA) is currently trading at a trailing P/E of 44.1x, which is higher than the industry average of 22.7x. While APA might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for APA Group
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 APA
Price-Earnings Ratio = Price per share ÷ Earnings per share
APA Price-Earnings Ratio = A$9.37 ÷ A$0.213 = 44.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to APA, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since APA’s P/E of 44.1x is higher than its industry peers (22.7x), it means that investors are paying more than they should for each dollar of APA’s earnings. As such, our analysis shows that APA represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your APA shares, 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 APA, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with APA, 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 APA to are fairly valued by the market. If this is violated, APA’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 overvaluation could signal a potential selling opportunity to reduce your exposure to APA. 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 you are considering investing in APA, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.