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This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Everest Industries Limited (NSE:EVERESTIND) trades with a trailing P/E of 15.4x, which is lower than the industry average of 23.8x. While this makes EVERESTIND 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
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What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for EVERESTIND
Price-Earnings Ratio = Price per share ÷ Earnings per share
EVERESTIND Price-Earnings Ratio = ₹528 ÷ ₹34.241 = 15.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to EVERESTIND, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. EVERESTIND’s P/E of 15.4 is lower than its industry peers (23.8), which implies that each dollar of EVERESTIND’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Building companies in IN including Nitco, Nitco and Sanco Industries. One could put it like this: the market is pricing EVERESTIND as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to EVERESTIND, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with EVERESTIND, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing EVERESTIND to are fairly valued by the market. If this does not hold, there is a possibility that EVERESTIND’s P/E is lower because our peer group is overvalued by the market.