To the annoyance of some shareholders, Imperial Oil (TSE:IMO) shares are down a considerable 36% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 46% drop over twelve months.
All else being equal, a share price drop should make a stock more attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
How Does Imperial Oil's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 6.94 that sentiment around Imperial Oil isn't particularly high. We can see in the image below that the average P/E (7.6) for companies in the oil and gas industry is higher than Imperial Oil's P/E.
This suggests that market participants think Imperial Oil will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Imperial Oil's earnings per share were pretty steady over the last year. But it has grown its earnings per share by 4.1% per year over the last three years. And EPS is down 8.4% a year, over the last 5 years. So we might expect a relatively low P/E.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. 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).
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Is Debt Impacting Imperial Oil's P/E?
Imperial Oil's net debt is 20% of its market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Bottom Line On Imperial Oil's P/E Ratio
Imperial Oil trades on a P/E ratio of 6.9, which is below the CA market average of 13.4. The company hasn't stretched its balance sheet, and earnings are improving. If growth is sustainable over the long term, then the current P/E ratio may be a sign of good value. What can be absolutely certain is that the market has become more pessimistic about Imperial Oil over the last month, with the P/E ratio falling from 10.8 back then to 6.9 today. For those who prefer invest in growth, this stock apparently offers limited promise, but the deep value investors may find the pessimism around this stock enticing.
Investors have an opportunity when market expectations about a stock are wrong. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Imperial Oil. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
If you spot an error that warrants correction, please contact the editor at email@example.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.
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