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Why Oil Search Limited's (ASX:OSH) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Oil Search Limited's (ASX:OSH) P/E ratio to inform your assessment of the investment opportunity. Oil Search has a price to earnings ratio of 17.97, based on the last twelve months. That means that at current prices, buyers pay A$17.97 for every A$1 in trailing yearly profits.

See our latest analysis for Oil Search

How Do You Calculate Oil Search's P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)

Or for Oil Search:

P/E of 17.97 = $5 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.28 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'

How Does Oil Search's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, Oil Search has a higher P/E than the average company (9.9) in the oil and gas industry.

ASX:OSH Price Estimation Relative to Market, September 16th 2019

That means that the market expects Oil Search will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. 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. Earnings growth means that in the future the 'E' will be higher. 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.

Oil Search's 68% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive.

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

Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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).

So What Does Oil Search's Balance Sheet Tell Us?

Oil Search's net debt equates to 38% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.

The Verdict On Oil Search's P/E Ratio

Oil Search has a P/E of 18. That's around the same as the average in the AU market, which is 18. With only modest debt levels, and strong earnings growth, the market seems to doubt that the growth can be maintained.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

But note: Oil Search 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).

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.

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. Thank you for reading.