The Santos Ltd (ASX: STO) share price has had a very solid year so far in 2023. Since January, Santos shares have risen by a healthy 8.05%, including the solid 1.59% this ASX 200 energy share added yesterday.
But despite this pleasing year-to-date performance, Santos shares are still trading on a price-to-earnings (P/E) ratio of just 8.33.
Prices and earnings
The P/E ratio is usually one of the first metrics a beginner investor will come across. It compares a company’s share price to its earnings per share (EPS). This enables a reasonably effective way to compare different shares’ valuations to see which ones are trading at a cheaper price relative to others.
For example, if one company has a P/E ratio of 20, then investors are being asked to pay $20 for every $1 in earnings the company brings in. If another company has a P/E ratio of 30, then it is arguably more expensive, because investors are paying a premium of $10 more for that same $1 of earnings.
Of course, different shares sell different goods and services to different customers. This can make it hard to assess the merits of a potential investment in a bank like National Australia Bank Ltd (ASX: NAB) compared to an oil company like Santos, or a tech share like Xero Limited (ASX: XRO).
But most ASX shares bring in earnings and profits, which make these earnings an easy way to compare the valuations of dissimilar companies.
So a P/E ratio of 8.33 looks cheap right off the bat. We can tell because the average of the entire S&P/ASX 200 Index (ASX: XJO) right now is 15.2.
That means that some companies, for example, Commonwealth Bank of Australia (ASX: CBA), Woolworths Group Ltd (ASX: WOW), and Tesltra Group Ltd (ASX: TLS) are trading with P/E ratios higher than 15.2 right now (which they are). While others, evidently Santos, are below it.
But does this automatically mean that Santos shares are a cheap buy right now?
Are Santos shares cheap at a P/E ratio of 8.33?
Well, not necessarily. While the P/E ratio is a useful metric, it is not without its faults. And it is especially unreliable when it comes to resources or energy shares like Santos.
That’s because all energy shares, Santos included, are highly cyclical. Their earnings depend almost entirely on the prices of oil and gas since Santos is a price taker in the open commodities market.
So, yes, Santos shares look cheap right now because that P/E ratio is based on the earnings the company has made over the past 12 months. But these earnings were made when energy prices were at reasonably high levels. Oil prices have been falling for most of the past year. Twelve months ago, WTI crude was fetching more than US$100 a barrel. Today, it is sitting at around US$75.
Thus, it’s highly unlikely that Santos will be able to generate the same level of earnings over the next 12 months if oil stays at its current level. That’s what is making the Santos share price look cheap on a P/E ratio basis right now.
If Santos does end up delivering lower earnings over the coming 12 months compared to the earnings of the past 12 months, this P/E ratio will rise if the share price stays the same. So keep that in mind before you rush off and buy ‘cheap’ Santos shares today.
