I am writing today to help inform people who are new to 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.
Vedanta Resources plc (LON:VED) trades with a trailing P/E of 12.9x, which is higher than the industry average of 12.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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 Vedanta Resources
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for VED
Price per share = $10.93
Earnings per share = $0.848
∴ Price-Earnings Ratio = $10.93 ÷ $0.848 = 12.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to VED, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
Since VED’s P/E of 12.9x is higher than its industry peers (12.3x), it means that investors are paying more than they should for each dollar of VED’s earnings. This multiple is a median of profitable companies of 24 Metals and Mining companies in GB including Cora Gold, Patagonia Gold and Ferrexpo. Therefore, according to this analysis, VED is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your VED shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to VED. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with VED, then investors would naturally value VED at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with VED, investors would also value VED at a higher price since it is a higher growth investment. Both scenarios would explain why VED has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing VED to are fairly valued by the market. If this assumption is violated, VED’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to VED. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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:
- Future Outlook: What are well-informed industry analysts predicting for VED’s future growth? Take a look at our free research report of analyst consensus for VED’s outlook.
- Past Track Record: Has VED been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of VED’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.