This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Atul Auto Limited (NSE:ATULAUTO) is currently trading at a trailing P/E of 18.5x, which is higher than the industry average of 17x. 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
What you need to know about 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for ATULAUTO
Price per share = ₹403.25
Earnings per share = ₹21.83
∴ Price-Earnings Ratio = ₹403.25 ÷ ₹21.83 = 18.5x
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 ATULAUTO, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since ATULAUTO’s P/E of 18.5x is higher than its industry peers (17x), it means that investors are paying more than they should for each dollar of ATULAUTO’s earnings. This multiple is a median of profitable companies of 19 Auto companies in IN including Hindustan Motors, Hindustan Motors and Tata Motors. 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 important assertions. The first is that our “similar companies” are actually similar to ATULAUTO. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with ATULAUTO, then ATULAUTO’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with ATULAUTO. In this case, ATULAUTO’s P/E would be higher since investors would also reward ATULAUTO’s higher growth with a higher price. 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 higher because firms in our peer group are being undervalued by the market.
What this means for you:
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 ATULAUTO. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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:
- Future Outlook: What are well-informed industry analysts predicting for ATULAUTO’s future growth? Take a look at our free research report of analyst consensus for ATULAUTO’s outlook.
- Past Track Record: Has ATULAUTO 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 ATULAUTO’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.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.