This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Housing Development Finance Corporation Limited (NSE:HDFC) trades with a trailing P/E of 19.3x, which is lower than the industry average of 20x. While HDFC might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Check out our latest analysis for Housing Development Finance
Breaking down 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 HDFC
Price-Earnings Ratio = Price per share ÷ Earnings per share
HDFC Price-Earnings Ratio = ₹1941.65 ÷ ₹100.352 = 19.3x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to HDFC, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since HDFC’s P/E of 19.3x is lower than its industry peers (20x), it means that investors are paying less than they should for each dollar of HDFC’s earnings. This multiple is a median of profitable companies of 9 Mortgage companies in IN including Indiabulls Housing Finance, Indiabulls Housing Finance and Sahara Housingfina. As such, our analysis shows that HDFC represents an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy HDFC, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to HDFC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with HDFC, 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 HDFC to are fairly valued by the market. If this does not hold true, HDFC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.