This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Magellan Midstream Partners LP (NYSE:MMP) is trading with a trailing P/E of 18.1, which is higher than the industry average of 12.3. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
P/E Calculation for MMP
Price-Earnings Ratio = Price per share ÷ Earnings per share
MMP Price-Earnings Ratio = $68.26 ÷ $3.775 = 18.1x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as MMP, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. MMP’s P/E of 18.1 is higher than its industry peers (12.3), which implies that each dollar of MMP’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Oil and Gas companies in US including Energem Resources, Longwei Petroleum Investment Holding and Petrosibir. You could think of it like this: the market is pricing MMP as if it is a stronger company than the average of its industry group.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to MMP. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Magellan Midstream Partners LP is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to MMP may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
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 rebalance your portfolio and reduce your holdings in MMP. 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 MMP’s future growth? Take a look at our free research report of analyst consensus for MMP’s outlook.
- Past Track Record: Has MMP 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 MMP’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.