The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
D P Abhushan Limited (NSE:DPABHUSHAN) is currently trading at a trailing P/E of 8.9x, which is lower than the industry average of 23.7x. While this makes DPABHUSHAN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
View our latest analysis for D. P. Abhushan
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for DPABHUSHAN
Price-Earnings Ratio = Price per share ÷ Earnings per share
DPABHUSHAN Price-Earnings Ratio = ₹41 ÷ ₹4.607 = 8.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to DPABHUSHAN, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. DPABHUSHAN’s P/E of 8.9 is lower than its industry peers (23.7), which implies that each dollar of DPABHUSHAN’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 17 Specialty Retail companies in IN including Competent Automobiles, Radhika Jeweltech and Yamuna Syndicate. One could put it like this: the market is pricing DPABHUSHAN as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to DPABHUSHAN. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with DPABHUSHAN, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DPABHUSHAN to are fairly valued by the market. If this does not hold true, DPABHUSHAN’s lower P/E ratio may be because firms in our peer group are overvalued by the market.