EXCO Resources Inc (NYSE:XCO) trades with a trailing P/E of 0.2x, which is lower than the industry average of 20.8x. While XCO 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for EXCO Resources
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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.
P/E Calculation for XCO
Price-Earnings Ratio = Price per share ÷ Earnings per share
XCO Price-Earnings Ratio = 1.27 ÷ 7.667 = 0.2x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as XCO, 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. XCO’s P/E of 0.2x is lower than its industry peers (20.8x), which implies that each dollar of XCO’s earnings is being undervalued by investors. Therefore, according to this analysis, XCO is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy XCO immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to XCO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with XCO, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing XCO to are fairly valued by the market. If this does not hold, there is a possibility that XCO’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on XCO, 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.
Are you a potential investor? If you are considering investing in XCO, 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 EXCO Resources 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.