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Atul Auto Limited (NSEI:ATULAUTO) is currently trading at a trailing P/E of 24.7x, which is higher than the industry average of 20.9x. While this makes ATULAUTO 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Atul Auto
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 ATULAUTO
Price-Earnings Ratio = Price per share ÷ Earnings per share
ATULAUTO Price-Earnings Ratio = ₹426.65 ÷ ₹17.248 = 24.7x
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 ATULAUTO, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. ATULAUTO’s P/E of 24.7x is higher than its industry peers (20.9x), which implies that each dollar of ATULAUTO’s earnings is being overvalued by investors. Therefore, according to this analysis, ATULAUTO is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that ATULAUTO should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to ATULAUTO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with ATULAUTO, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing ATULAUTO to are fairly valued by the market. If this does not hold, there is a possibility that ATULAUTO’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on ATULAUTO, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: