One way in which stocks are valued is the price to earnings ratio, commonly abbreviated as P/E or p/e. It is a fairly simple calculation that divides a stock’s price by the company’s earnings per share for a given 12-month period. The logic of the ratio is that by owning a share of a company you are, arguably, buying the future stream of earnings the company generates.
If a company’s earnings are growing strongly, investors might logically assume that today’s earnings are worth more because of the potential for future growth. Conversely, if a company’s earnings are growing slowly or unevenly, it wouldn’t make logical sense to pay a premium. This last statement highlights an important aspect of the P/E ratio—by itself it provides minimal information. To properly use the P/E as a valuation tool, it must be compared to something.
In many cases, an individual P/E is compared to the average P/E of the broader market. Value Line publishes the P/E of the market each week for this very purpose. Moreover, each Value Line research report contains both the actual P/E and the company’s relative P/E. A relative P/E above 1.00 suggests a valuation level above that of the broader market and a relative P/E below one suggests a valuation level below that of the market. Another common comparison is to consider the current P/E versus a company’s historical P/E ratio. This information is provided in the historical section of the Statistical Array on each Value Line report. Price to earnings ratios can also be compared between peers, to spotlight the companies in an industry that are trading at a high price and pinpoint the ones that are trading relatively inexpensively. As a valuation tool the P/E is very valuable and should be a part of every investors’ toolkit.
Very often, a P/E is best used to simply cut companies from a list of research candidates. It is, indeed, a quick way to pull out companies that are trading relatively cheaply from a much wider group. To this end, each week The Value Line Investment Survey contains a listing of the 100 companies with the lowest price to earnings ratios out of the approximately 1,700 followed by the Survey. For value-oriented investors, this list of low Price to Earnings ratio stocks is a great place to start looking for investment ideas. Below is information on one company that was recently found on this list, Forest Oil Corporation (FST).
Forest Oil Corporation
Forest is a small-cap U.S. company engaged in the acquisition, exploration, development, and production of oil, natural gas, and natural gas liquids (NGL). It now runs mostly horizontal drilling operations located in the Eagle Ford Shale in South Texas and the East Texas / North Louisiana Area, and has no immediate plans to develop new markets. For the nine months ended September 30th, those categories accounted for 49%, 34%, and 17% of revenues, respectively. Fluctuations in the market prices for these natural resources have a significant impact on the company’s financial results and also influence decisions on capital expenditure and hedging activity. The resulting stock price volatility helps explain FST’s poor marks for Safety (4) and Stock Price Stability (25).
In November, 2013, the company completed the sale of its Texas Panhandle assets for $1 billion in cash. Management intends to use these funds to pay down debt on Forest's highly leveraged balance sheet. We think this was an appropriate move considering long-term debt has exceeded total capital since late 2012 and has been over 50% for years. The more attractive balance sheet will likely get more risk-averse investors to consider the shares.
In its September quarter earnings report, the company gave 2014 output guidance that was largely in line with Wall Street’s expectations. Also, the company is looking for the product mix to shift toward more profitable crude oil. Indeed, Eagle Ford production guidance of 5,800 to 6,600 boe/d would mark more than double the amount produced in 2013. Capital Expenditure should be moderately higher than last year, and production expenses are set to rise a decent amount also, due to a larger-than-expected impact from cutting the panhandle assets. Further, overall volumes are set to come down significantly as the Panhandle formerly accounted for a little less than half of Forest’s total output. On the bright side, earnings per share should see a lift from a near 0% tax rate in 2014, which is stemming from changes in the valuation allowance on Forest’s deferred tax assets.
Since the decent September results were released, the stock price has fallen around 30%, a stark contrast to the near 30% rise in spot prices for natural gas. Shares of FST are now trading around 1% above their 52 week low. Although the high debt load, uncertain demand environment, and transition to oil products all add risk, we think the long-term potential for the company to capitalize on its proven reserves should appeal to risk-tolerant, long-term investors.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.