This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
HollyFrontier Corporation (NYSE:HFC) is currently trading at a trailing P/E of 8.2x, which is lower than the industry average of 14.7x. While this makes HFC appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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
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 HFC
Price-Earnings Ratio = Price per share ÷ Earnings per share
HFC Price-Earnings Ratio = $64.8 ÷ $7.946 = 8.2x
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 HFC, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. HFC’s P/E of 8.2 is lower than its industry peers (14.7), which implies that each dollar of HFC’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Oil and Gas companies in US including Vanguard Natural Resources, Grupo TMM and PEDEVCO. You can think of it like this: the market is suggesting that HFC is a weaker business than the average comparable company.
A few caveats
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to HFC. 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 HFC, 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 HFC to are fairly valued by the market. If this does not hold, there is a possibility that HFC’s P/E is lower because our peer group is 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 HFC. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for HFC’s future growth? Take a look at our free research report of analyst consensus for HFC’s outlook.
- Past Track Record: Has HFC 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 HFC’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.