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Why Marathon Oil Corporation's (NYSE:MRO) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Marathon Oil Corporation's (NYSE:MRO) P/E ratio could help you assess the value on offer. Marathon Oil has a P/E ratio of 11.96, based on the last twelve months. That is equivalent to an earnings yield of about 8.4%.

Check out our latest analysis for Marathon Oil

How Do I Calculate Marathon Oil's Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Marathon Oil:

P/E of 11.96 = $13.03 ÷ $1.09 (Based on the year to September 2019.)

Is A High Price-to-Earnings 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.

Does Marathon Oil Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (10.0) for companies in the oil and gas industry is lower than Marathon Oil's P/E.

NYSE:MRO Price Estimation Relative to Market, December 13th 2019

That means that the market expects Marathon Oil will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.

Marathon Oil increased earnings per share by a whopping 37% last year. In contrast, EPS has decreased by 9.0%, annually, over 5 years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its 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).

Marathon Oil's Balance Sheet

Net debt is 42% of Marathon Oil's market cap. You'd want to be aware of this fact, but it doesn't bother us.

The Bottom Line On Marathon Oil's P/E Ratio

Marathon Oil trades on a P/E ratio of 12.0, which is below the US market average of 18.7. The company hasn't stretched its balance sheet, and earnings growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.

Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Marathon Oil may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.

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. Thank you for reading.