This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
TAG Oil Ltd (TSE:TAO) trades with a trailing P/E of 8.2x, which is lower than the industry average of 21.2x. While TAO might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for TAG Oil
What you need to know about the P/E ratio
P/E is a popular ratio used for 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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for TAO
Price per share = CA$0.37
Earnings per share = CA$0.0449
∴ Price-Earnings Ratio = CA$0.37 ÷ CA$0.0449 = 8.2x
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 TAO, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
TAO’s P/E of 8.2x is lower than its industry peers (21.2x), which implies that each dollar of TAO’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Oil and Gas companies in CA including McChip Resources, Greencastle Resources and Pinedale Energy. Therefore, according to this analysis, TAO is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy TAO, 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 TAO. 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 TAO, then investors would naturally value TAO at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with TAO, investors would also value TAO at a lower price since it is a lower growth investment. Both scenarios would explain why TAO has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing TAO to are fairly valued by the market. If this does not hold, there is a possibility that TAO’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to TAO. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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:
- Financial Health: Are TAO’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has TAO 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 TAO’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 past 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 editorial-team@simplywallst.com.