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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.
Hindustan Unilever Limited (NSE:HINDUNILVR) is currently trading at a trailing P/E of 64.4, which is higher than the industry average of 35. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, 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 Hindustan Unilever
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 HINDUNILVR
Price-Earnings Ratio = Price per share ÷ Earnings per share
HINDUNILVR Price-Earnings Ratio = ₹1551 ÷ ₹24.08 = 64.4x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as HINDUNILVR, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. HINDUNILVR’s P/E of 64.4 is higher than its industry peers (35), which implies that each dollar of HINDUNILVR’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 4 Household Products companies in IN including Pee Cee Cosma Sope, Eveready Industries India and Jyothy Laboratories. You could also say that the market is suggesting that HINDUNILVR is a stronger business than the average comparable company.
Assumptions to be aware of
However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to HINDUNILVR. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Hindustan Unilever Limited is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to HINDUNILVR may not be fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.