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.
Archer Limited (OB:ARCHER) is currently trading at a trailing P/E of 1.8x, which is lower than the industry average of 15.1x. 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.
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. 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 ARCHER
Price per share = $1.08
Earnings per share = $0.611
∴ Price-Earnings Ratio = $1.08 ÷ $0.611 = 1.8x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ARCHER, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 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.
ARCHER’s P/E of 1.8x is lower than its industry peers (15.1x), which implies that each dollar of ARCHER’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 9 Energy Services companies in NO including Awilco Drilling, Kværner and Ocean Yield. As such, our analysis shows that ARCHER represents an under-priced stock.
A few caveats
However, before you rush out to buy ARCHER, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to ARCHER. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with ARCHER, then investors would naturally value ARCHER at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with ARCHER, investors would also value ARCHER at a lower price since it is a lower growth investment. Both scenarios would explain why ARCHER has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ARCHER to are fairly valued by the market. If this does not hold, there is a possibility that ARCHER’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 ARCHER, 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 ARCHER’s future growth? Take a look at our free research report of analyst consensus for ARCHER’s outlook.
- Past Track Record: Has ARCHER 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 ARCHER’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 firstname.lastname@example.org.