Is It Time To Buy Woodside Petroleum Ltd (ASX:WPL) Based Off Its PE Ratio?
Woodside Petroleum Ltd (ASX:WPL) trades with a trailing P/E of 18.5x, which is lower than the industry average of 24.1x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Woodside Petroleum
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in 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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for WPL
Price per share = 28.77
Earnings per share = 1.231
∴ Price-Earnings Ratio = 28.77 ÷ 1.231 = 18.5x
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 WPL, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
WPL’s P/E of 18.5x is lower than its industry peers (24.1x), which implies that each dollar of WPL’s earnings is being undervalued by investors. Therefore, according to this analysis, WPL is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that WPL represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to WPL. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with WPL, then investors would naturally value WPL at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with WPL, investors would also value WPL at a lower price since it is a lower growth investment. Both scenarios would explain why WPL has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing WPL to are fairly valued by the market. If this assumption does not hold true, WPL’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? 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 WPL. 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.
Are you a potential investor? If you are considering investing in WPL, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
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 Woodside Petroleum 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.
