Market Overview

Does Cabot Merit a "High" P/E Ratio?

Does Cabot Merit a "High" P/E Ratio?

Fundamental analysts and value investors alike have an affinity for price-to-earnings ratios, both of the trailing 12 months and forward varietals. To be sure, a stock's P/E ratio does not tell the entire story of whether said stock is a "buy" or a "good value," but the metric is easy to comprehend and can be an important part of a more comprehensive fundamental screen.

A P/E ratio is merely a stock's current price divided by expected or reported earnings per share. For example, a stock trading at $50 with expected forward earnings per share of $10 would have a forward P/E ratio of five.

Cabot Oil & Gas (NYSE: COG) is a stock that has a forward P/E ratio that arguably appears high. (Arguably because a case can be made that this stock is not expensive, although there are valid downside concerns.)

Cabot is a Texas-based independent producer of oil and natural gas. Independent energy companies have no refining, or downstream operations, as do integrated oil firms such as Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX). Cabot should not be compared to those companies (and not just because its market value is less than 5% of Chevron's).

Combing the facts that Cabot touched a new 52-week high Wednesday, shares are up 20 percent year-to-date and sport a forward P/E of nearly 53, according to Thomson Reuters data. Without considering any other factors, this could lead one to believe that the stock is expensive. For example, Cabot's P/E is more than triple that of Anadarko Petroleum's (NYSE: APC) and quadruple that of Devon Energy's (NYSE: DVN), two larger energy independents.

Cabot is also highly dependent on natural gas. At the end of last year, 96 percent of the company's proven reserves were natural gas.

This is a natural gas story at a time when prices for that commodity remain weak. That alone could be enough to chase some investors away from the stock. Throw in that forward P/E of almost 53, and the unknowing would be heading for the exits.

On the other hand, there has to be a valid reason(s) why Cabot has performed well this year and is flirting with new highs, right? A small part of the story is that Cabot is cheaper than Range Resources (NYSE: RRC), another dominant player in the Marcellus Shale. Range currently fetches nearly 64 times its projected forward earnings.

That might be a petty comparison to some, so toss it aside and there are still some statistics that indicate Cabot's valuation is not too frothy. In July, the company forecast 2012 production growth of 35 percent to 50 percent and liquids production growth of 55 percent to 65 percent. Cabot expects 2013 production growth of 30 percent.

When JP Morgan upgraded Cabot to Overweight from Neutral last month, the bank said, "We forecast 40% production growth in 2012 and 34% in 2013 versus the group at 11% and 10%, respectively. Cabot is one of the fastest growers in the E&P sector. Cabot's above average growth comes with the company spending closer to cash flow than its peers with a stronger balance sheet."

The bank has a $54.50 price target on Cabot. Canacord has a $69 price target on Cabot. Split the difference between those two price targets and the result is still a number well above where the shares currently trade.

For the most recently reported quarter, Cabot had a debt-to-assets ratio of 25 percent and operating cash flow of $300 million, two more positives. The bottom line is Cabot's valuation is not stretched, but the shares could use the benefit of higher natural gas prices at some point to help the upside cause.

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