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Phillips 66 (NYSE:PSX) trades with a trailing P/E of 11x, which is lower than the industry average of 12.8x. 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Phillips 66
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for PSX
Price-Earnings Ratio = Price per share ÷ Earnings per share
PSX Price-Earnings Ratio = $109.23 ÷ $9.901 = 11x
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 PSX, 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 PSX’s P/E of 11x is lower than its industry peers (12.8x), it means that investors are paying less than they should for each dollar of PSX’s earnings. As such, our analysis shows that PSX represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy PSX immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to PSX. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with PSX, 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 PSX to are fairly valued by the market. If this is violated, PSX’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
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 PSX 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: