Imperial Oil Limited (TSX:IMO) is trading with a trailing P/E of 12.5x, which is lower than the industry average of 22.1x. While this makes IMO 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Imperial Oil
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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 IMO
Price-Earnings Ratio = Price per share ÷ Earnings per share
IMO Price-Earnings Ratio = 39.84 ÷ 3.19 = 12.5x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as IMO, 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. Since IMO's P/E of 12.5x is lower than its industry peers (22.1x), it means that investors are paying less than they should for each dollar of IMO's earnings. As such, our analysis shows that IMO represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that IMO is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to IMO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with IMO, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing IMO to are fairly valued by the market. If this does not hold, there is a possibility that IMO’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of IMO to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If IMO has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Imperial Oil for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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.