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.
Noble Energy Inc (NYSE:NBL) is trading with a trailing P/E of 16, which is higher than the industry average of 14.7. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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.
Check out our latest analysis for Noble Energy
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in 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 NBL
Price-Earnings Ratio = Price per share ÷ Earnings per share
NBL Price-Earnings Ratio = $29.22 ÷ $1.831 = 16x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as NBL, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 16, NBL’s P/E is higher than its industry peers (14.7). This implies that investors are overvaluing each dollar of NBL’s earnings. This multiple is a median of profitable companies of 25 Oil and Gas companies in US including Vanguard Natural Resources, Grupo TMM and PEDEVCO. You could think of it like this: the market is pricing NBL as if it is a stronger company than the average of its industry group.
A few caveats
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to NBL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Noble Energy Inc is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with NBL are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on NBL, the overvaluation of the stock may mean it is a good time to reduce 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: