Here's How P/E Ratios Can Help Us Understand RAK Petroleum plc (OB:RAKP)

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how RAK Petroleum plc's (OB:RAKP) P/E ratio could help you assess the value on offer. RAK Petroleum has a price to earnings ratio of 1.71, based on the last twelve months. That is equivalent to an earnings yield of about 58.6%.

Check out our latest analysis for RAK Petroleum

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)

Or for RAK Petroleum:

P/E of 1.71 = USD1.01 (Note: this is the share price in the reporting currency, namely, USD ) ÷ USD0.59 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each USD1 of company earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Does RAK Petroleum's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (17.5) for companies in the oil and gas industry is higher than RAK Petroleum's P/E.

RAK Petroleum's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

RAK Petroleum's 120% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

How Does RAK Petroleum's Debt Impact Its P/E Ratio?

RAK Petroleum has net debt worth a very significant 168% of its market capitalization. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.

The Verdict On RAK Petroleum's P/E Ratio

RAK Petroleum has a P/E of 1.7. That's below the average in the NO market, which is 15.5. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If it continues to grow, then the current low P/E may prove to be unjustified.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

You might be able to find a better buy than RAK Petroleum. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.