As of September 2016, energy companies are trading at prices lower than their valuations. Several companies, including Sasol Ltd. (SSL, Financial) and Helmerich & Payne Inc. (HP, Financial), also have a high profitability rank, suggesting high growth potential.
Brief introduction to the key earnings and valuation ratios
As discussed in a previous article, Peter Lynch prefers companies that are undervalued based on their earnings. The three key valuation ratios are the price-earnings ratio, the price-to-book ratio and the price-to-sales ratio. Each of the three valuation ratios offers a different perspective on the fair value of a company.
Likely the most commonly used valuation ratio, the P/E ratio measures the company’s stock price relative to its earnings per share. The distribution of P/E ratios among companies trading on the New York Stock Exchange and the Nasdaq is right skewed with a median of 25.4 and a standard deviation of 42.6, suggesting that P/E ratios can fluctuate wider than the P/B and P/S ratios.
As Lynch observed during his investing career, the P/E ratio can give misleading information about the valuation of a company, especially in cyclical industries. The other two key valuation ratios, especially the P/S ratio, generally give more useful valuations. First used by Ken Fisher (Trades, Portfolio), the P/S ratio measures the company’s stock price relative to its per-share revenue. Among the valuation ratios, the P/S ratio best compares a company’s current valuations to historical valuations as profit margins generally revert to the mean in the short term.
Except for a few outliers, the distribution of P/S ratios among NYSE and Nasdaq companies is narrower than the distribution of P/E ratios among the same set of companies. Among the industries whose average P/S ratio is less than 55, the median is 1.82 with a standard deviation of just 4.42.
Significantly undervalued energy sector offers growth opportunities
As discussed earlier, the P/E ratio can understate the true value of cyclical companies. To account for fluctuations due to profit margin variation, Yale professor Robert Shiller invented the Shiller P/E ratio, which is the company’s share price divided by the E10, the average inflation-adjusted earnings for the past 10 years. Based on current sector valuations, the energy sector has the lowest among companies trading on the Standard & Poor’s 500 index, most likely due to crude oil prices still languishing near five-year lows.
The “Undervalued Energy Screener” looks for energy companies that meet the following criteria:
- The company has at least a one-star predictability rank.
- The company has a trailing 12-month P/E less than 14, a P/B ratio less than 5, and a P/S ratio less than 2.
- The company’s 10-year revenue growth rate is at least 6%.
When the Undervalued Energy strategy ranked the company stocks by increasing trailing 12-month P/E, the test portfolio returned about 79%, outperforming the S&P 500 exchange-traded fund by roughly 5%.
| Year | SP 500 ETF | Rank by Predict DESC | Rank by P/E (ttm) ASC | Rank by P/S ASC | Rank by P/B ASC |
| 2006 | 13.74% | 28.95% | 28.95% | 28.95% | 28.95% |
| 2007 | 3.24% | 24.48% | 24.48% | 24.48% | 24.48% |
| 2008 | -38.28% | -41.65% | -41.65% | -41.65% | -41.65% |
| 2009 | 23.49% | 39.11% | 56.41% | 44.28% | 56.19% |
| 2010 | 12.84% | 29.47% | 29.47% | 29.47% | 29.47% |
| 2011 | -0.20% | 22.78% | 22.78% | 22.78% | 22.78% |
| 2012 | 13.47% | 4.78% | 4.38% | 4.44% | 4.52% |
| 2013 | 29.69% | 27.16% | 28.48% | 26.28% | 24.38% |
| 2014 | 11.29% | -11.95% | -11.95% | -11.95% | -11.95% |
| 2015 | -0.81% | -38.80% | -40.87% | -38.44% | -40.10% |
| 2016 YTD | 6.17% | 13.44% | 10.15% | 7.25% | 9.32% |
| Overall | 73.84% | 68.71% | 79.12% | 64.71% | 74.33% |
Sasol (SSL, Financial), a South African energy and chemicals company, currently has a profitability rank of 9, suggesting high growth potential. The company’s P/S ratio of 1.28 is near a 10-year low, and ranked lower than 69% of global oil & gas – integrated companies. Additionally, the company’s operating margin has steadily increased during the seven-year period from 2009 to 2015.
Like Sasol, Helmerich & Payne (HP, Financial) has a high profitability rank. Even though the company’s operating margin sharply declined in the past quarter, the company seldom had operating margins under 20% during the past 10 years. This suggests that the company still has potential for growth as profit margins tend to revert to the mean.
As the South African energy company has high growth potential, Jim Simons (Trades, Portfolio) increased his Sasol position by 73.45% during the second quarter.
See also
GuruFocus offers two value screeners that list companies with historical low P/S and P/B ratios. These strategies have outperformed the S&P 500 in at least seven of the past nine years based on model portfolio information.
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Disclosure: The author has no position in the stocks mentioned in this article.
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