Is Oil Search Limited’s (ASX:OSH) High P/E Ratio A Problem For Investors?

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Oil Search Limited’s (ASX:OSH) P/E ratio could help you assess the value on offer. Oil Search has a P/E ratio of 18.26, based on the last twelve months. That corresponds to an earnings yield of approximately 5.5%.

View our latest analysis for Oil Search

How Do You Calculate Oil Search’s P/E Ratio?

The formula for P/E is:

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

Or for Oil Search:

P/E of 18.26 = A$5.08 (Note: this is the share price in the reporting currency, namely, USD ) ÷ A$0.28 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.

Does Oil Search Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. As you can see below, Oil Search has a higher P/E than the average company (9.0) in the oil and gas industry.

ASX:OSH Price Estimation Relative to Market, November 8th 2019
ASX:OSH Price Estimation Relative to Market, November 8th 2019

That means that the market expects Oil Search will outperform other companies in its industry.

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. Earnings growth means that in the future the ‘E’ will be higher. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

In the last year, Oil Search grew EPS like Taylor Swift grew her fan base back in 2010; the 68% gain was both fast and well deserved. Shareholders have some reason to be optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.

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. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

How Does Oil Search’s Debt Impact Its P/E Ratio?

Oil Search’s net debt equates to 37% of its market capitalization. While it’s worth keeping this in mind, it isn’t a worry.

The Bottom Line On Oil Search’s P/E Ratio

Oil Search has a P/E of 18.3. That’s around the same as the average in the AU market, which is 18.7. Given it has reasonable debt levels, and grew earnings strongly last year, the P/E indicates the market has doubts this growth can be sustained.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Oil Search may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.

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. Thank you for reading.