This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Saudi Arabian Oil Company’s (TADAWUL:2222) P/E ratio and reflect on what it tells us about the company’s share price. Saudi Arabian Oil has a P/E ratio of 17.29, based on the last twelve months. That corresponds to an earnings yield of approximately 5.8%.
View our latest analysis for Saudi Arabian Oil
How Do I Calculate Saudi Arabian Oil’s Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Saudi Arabian Oil:
P/E of 17.29 = SAR31.150 ÷ SAR1.801 (Based on the year to September 2019.)
(Note: the above calculation results may not be precise due to rounding.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each SAR1 of company earnings. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price’.
Does Saudi Arabian Oil Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Saudi Arabian Oil has a higher P/E than the average (8.4) P/E for companies in the oil and gas industry.
That means that the market expects Saudi Arabian Oil will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Saudi Arabian Oil’s earnings per share fell by 5.9% in the last twelve months.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. So it won’t reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
So What Does Saudi Arabian Oil’s Balance Sheet Tell Us?
Since Saudi Arabian Oil holds net cash of ر.س84b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Saudi Arabian Oil’s P/E Ratio
Saudi Arabian Oil’s P/E is 17.3 which is below average (19.2) in the SA market. The recent drop in earnings per share would almost certainly temper expectations, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there’s real potential that the low P/E could eventually indicate undervaluation.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Saudi Arabian Oil. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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