Imperial Oil Limited (TSX:IMO) trades with a trailing P/E of 11.9x, which is lower than the industry average of 27.5x. While IMO 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Imperial Oil
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 IMO
Price per share = 37.98
Earnings per share = 3.19
∴ Price-Earnings Ratio = 37.98 ÷ 3.19 = 11.9x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to IMO, 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.
IMO’s P/E of 11.9x is lower than its industry peers (27.5x), which implies that each dollar of IMO’s earnings is being undervalued by investors. Therefore, according to this analysis, IMO is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy IMO immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to IMO. 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 IMO, then investors would naturally value IMO at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with IMO, investors would also value IMO at a lower price since it is a lower growth investment. Both scenarios would explain why IMO has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing IMO to are fairly valued by the market. If this assumption does not hold true, IMO’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? 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 IMO. 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.
Are you a potential investor? If you are considering investing in IMO, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Imperial Oil for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass 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.