Chevron Corporation (NYSE: CVX) trades at a P/E multiple of 23.5x, which is higher than the Energy sector median of 15.6x. While this makes CVX appear like a stock to avoid or sell if you own it, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

Understanding Valuation Multiples and the P/E Ratio

A Multiples Valuation, also known as a Comparable Companies Analysis, determines the value of a subject company by benchmarking the subject's financial performance against similar public companies (Peer Group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.

A P/E Multiple is a valuation ratio that indicates the multiple of earnings investors are willing to pay for one share of a company:

P/E Multiple = Stock Price ÷ Earnings Per Share

The P/E ratio is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different. I compare Chevron's P/E multiple to those of Exxon Mobil Corporation (NYSE: XOM), TOTAL S.A. (NYSE: TOT), Phillips 66 (NYSE: PSX) and Valero Energy Corporation (NYSE: VLO) in the chart below.

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source: finbox.io Benchmarks: P/E Multiples

Since Chevron's P/E of 23.5x is higher than the median of its peers (12.7x), it means that investors are paying more than they should for each dollar of CVX's earnings. As such, our analysis shows that CVX represents an overvalued stock. In fact, finbox.io's P/E Multiple Model calculates a fair value of $83.27 per share which implies -27.8% downside.

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Note that the selected multiple of 17.3x in the analysis above was determined by averaging Chevron's current P/E multiple with its peer group and sector.

Understanding the P/E Ratio's Limitations

Before jumping to the conclusion that Chevron should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.

(1) the selected peer group actually contains companies that truly are similar to Chevron, and

(2) the selected peer group stocks are being fairly valued by the market.

If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare Chevron with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.

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source: P/E model

Now if the second assumption does not hold true, Chevron's higher multiple may be because firms in our peer group are being undervalued by the market.

What This Means For Investors

As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to CVX. However, keep in mind the limitations of the P/E ratio when making investment decisions.