Advantage Oil & Gas Ltd (TSX:AAV) is currently trading at a trailing P/E of 8.3x, which is lower than the industry average of 15.5x. While this makes AAV appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Advantage Oil & Gas
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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.
P/E Calculation for AAV
Price-Earnings Ratio = Price per share ÷ Earnings per share
AAV Price-Earnings Ratio = CA$4.25 ÷ CA$0.512 = 8.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to AAV, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. AAV’s P/E of 8.3x is lower than its industry peers (15.5x), which implies that each dollar of AAV’s earnings is being undervalued by investors. Therefore, according to this analysis, AAV is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that AAV is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to AAV. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with AAV, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing AAV to are fairly valued by the market. If this does not hold, there is a possibility that AAV’s P/E is lower because our peer group is overvalued by the market.
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.