Western Gas Equity Partners LP (NYSE:WGP) trades with a trailing P/E of 19.2x, which is higher than the industry average of 12.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Western Gas Equity Partners
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 WGP
Price-Earnings Ratio = Price per share ÷ Earnings per share
WGP Price-Earnings Ratio = $33.02 ÷ $1.72 = 19.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to WGP, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since WGP’s P/E of 19.2x is higher than its industry peers (12.3x), it means that investors are paying more than they should for each dollar of WGP’s earnings. As such, our analysis shows that WGP represents an over-priced stock.
A few caveats
Before you jump to the conclusion that WGP should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to WGP. 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 WGP, 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 WGP to are fairly valued by the market. If this is violated, WGP’s P/E may be lower than its peers as they are actually overvalued by investors.
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.