I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Advantage Oil & Gas Ltd (TSE:AAV) is trading with a trailing P/E of 12.4x, which is lower than the industry average of 20.8x. While this makes AAV appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AAV
Price per share = CA$4.21
Earnings per share = CA$0.338
∴ Price-Earnings Ratio = CA$4.21 ÷ CA$0.338 = 12.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AAV, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
AAV’s P/E of 12.4x is lower than its industry peers (20.8x), which implies that each dollar of AAV’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Oil and Gas companies in CA including Primeline Energy Holdings, McChip Resources and Greencastle Resources. Therefore, according to this analysis, AAV is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy AAV immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AAV. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with AAV, then AAV’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with AAV, AAV’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing AAV to are fairly valued by the market. If this does not hold, there is a possibility that AAV’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on AAV, the undervaluation of the stock may mean it is a good time to top up on 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:
- Future Outlook: What are well-informed industry analysts predicting for AAV’s future growth? Take a look at our free research report of analyst consensus for AAV’s outlook.
- Past Track Record: Has AAV been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of AAV’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.