I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Solaris Oilfield Infrastructure Inc (NYSE:SOI) trades with a trailing P/E of 14.6x, which is lower than the industry average of 16.9x. While this makes SOI appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the Price-Earnings 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 SOI
Price-Earnings Ratio = Price per share ÷ Earnings per share
SOI Price-Earnings Ratio = $17.05 ÷ $1.169 = 14.6x
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 SOI, 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. SOI’s P/E of 14.6 is lower than its industry peers (16.9), which implies that each dollar of SOI’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Energy Services companies in US including Covia Holdings, AFG Holdings and Seadrill Partners. One could put it like this: the market is pricing SOI as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to SOI. 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 SOI, 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 SOI to are fairly valued by the market. If this does not hold true, SOI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to SOI. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 SOI’s future growth? Take a look at our free research report of analyst consensus for SOI’s outlook.
- Financial Health: Are SOI’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- 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.