Perfect Infraengineers Limited (NSEI:PERFECT) trades with a trailing P/E of 38.4x, which is higher than the industry average of 32.7x. While this makes PERFECT appear like a stock to avoid or sell if you own it, 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. Check out our latest analysis for Perfect Infraengineers
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. 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 PERFECT
Price-Earnings Ratio = Price per share ÷ Earnings per share
PERFECT Price-Earnings Ratio = ₹29.9 ÷ ₹0.778 = 38.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to PERFECT, 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. PERFECT’s P/E of 38.4x is higher than its industry peers (32.7x), which implies that each dollar of PERFECT’s earnings is being overvalued by investors. Therefore, according to this analysis, PERFECT is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your PERFECT shares, 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 PERFECT, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with PERFECT, 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 PERFECT to are fairly valued by the market. If this is violated, PERFECT’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in PERFECT. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.