Should You Be Tempted To Buy Advantage Oil & Gas Ltd (TSE:AAV) Because Of Its PE Ratio?

Advantage Oil & Gas Ltd (TSX:AAV) is trading with a trailing P/E of 15.5x, which is lower than the industry average of 16.7x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Advantage Oil & Gas

Demystifying the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for AAV

Price per share = CA\$5.4

Earnings per share = CA\$0.35

∴ Price-Earnings Ratio = CA\$5.4 ÷ CA\$0.35 = 15.5x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AAV, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.

Since AAV’s P/E of 15.5x is lower than its industry peers (16.7x), it means that investors are paying less than they should for each dollar of AAV’s earnings. As such, our analysis shows that AAV represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy AAV, it is important to note that this conclusion is based on two key assumptions. 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 inadvertently compared lower risk firms with AAV, then investors would naturally value AAV at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with AAV, investors would also value AAV at a lower price since it is a lower growth investment. Both scenarios would explain why AAV has a lower P/E ratio than its peers. 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 urge you to complete your research by taking a look at the following: