This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Concho Resources Inc.’s (NYSE:CXO) P/E ratio could help you assess the value on offer. Concho Resources has a P/E ratio of 8.17, based on the last twelve months. That means that at current prices, buyers pay $8.17 for every $1 in trailing yearly profits.
How Do You Calculate Concho Resources’s P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Concho Resources:
P/E of 8.17 = $108.47 ÷ $13.27 (Based on the trailing twelve months to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
Concho Resources increased earnings per share by a whopping 106% last year. And its annual EPS growth rate over 5 years is 18%. So we’d generally expect it to have a relatively high P/E ratio.
How Does Concho Resources’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Concho Resources has a lower P/E than the average (12.2) in the oil and gas industry classification.
This suggests that market participants think Concho Resources will underperform other companies in its industry. Since the market seems unimpressed with Concho Resources, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does Concho Resources’s Debt Impact Its P/E Ratio?
Concho Resources’s net debt is 20% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Bottom Line On Concho Resources’s P/E Ratio
Concho Resources has a P/E of 8.2. That’s below the average in the US market, which is 17.6. The company hasn’t stretched its balance sheet, and earnings growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
Investors have an opportunity when market expectations about a stock are wrong. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.