Is Imperial Oil Limited’s (TSE:IMO) P/E Ratio Really That Good?

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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll look at Imperial Oil Limited’s (TSE:IMO) P/E ratio and reflect on what it tells us about the company’s share price. Imperial Oil has a P/E ratio of 13.67, based on the last twelve months. That corresponds to an earnings yield of approximately 7.3%.

View our latest analysis for Imperial Oil

How Do I Calculate Imperial 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 Imperial Oil:

P/E of 13.67 = CA$35.96 ÷ CA$2.63 (Based on the year to March 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Imperial Oil’s earnings made like a rocket, taking off 228% last year. Even better, EPS is up 55% per year over three years. So you might say it really deserves to have an above-average P/E ratio. On the other hand, the longer term performance is poor, with EPS down 5.6% per year over 5 years.

How Does Imperial Oil’s P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (13.8) for companies in the oil and gas industry is roughly the same as Imperial Oil’s P/E.

TSX:IMO Price Estimation Relative to Market, June 4th 2019
TSX:IMO Price Estimation Relative to Market, June 4th 2019

That indicates that the market expects Imperial Oil will perform roughly in line with other companies in its industry. So if Imperial Oil actually outperforms its peers going forward, that should be a positive for the share price. I inform my view byby checking management tenure and remuneration, among other things.

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

Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.

Imperial Oil’s Balance Sheet

Imperial Oil has net debt worth 16% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Verdict On Imperial Oil’s P/E Ratio

Imperial Oil has a P/E of 13.7. That’s below the average in the CA market, which is 14.8. The company hasn’t stretched its balance sheet, and earnings growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. Because analysts are predicting more growth in the future, one might have expected to see a higher P/E ratio. You can taker closer look at the fundamentals, here.

When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than Imperial Oil. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.