Eidesvik Offshore ASA (OB:EIOF) trades with a trailing P/E of 1.1x, which is lower than the industry average of 9.7x. 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Eidesvik Offshore
What you need to know about 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for EIOF
Price per share = NOK5.7
Earnings per share = NOK5.153
∴ Price-Earnings Ratio = NOK5.7 ÷ NOK5.153 = 1.1x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as EIOF, 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 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.
At 1.1x, EIOF’s P/E is lower than its industry peers (9.7x). This implies that investors are undervaluing each dollar of EIOF’s earnings. As such, our analysis shows that EIOF represents an under-priced stock.
A few caveats
Before you jump to the conclusion that EIOF represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to EIOF. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with EIOF, then EIOF’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 EIOF, EIOF’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 EIOF to are fairly valued by the market. If this does not hold, there is a possibility that EIOF’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of EIOF to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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:
- Future Outlook: What are well-informed industry analysts predicting for EIOF’s future growth? Take a look at our free research report of analyst consensus for EIOF’s outlook.
- Past Track Record: Has EIOF 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 EIOF’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.