Does Tata Motors Limited's (NSE:TATAMTRDVR) PE Ratio Signal A Buying Opportunity?

Tata Motors Limited (NSEI:TATAMTRDVR) is currently trading at a trailing P/E of 20.5x, which is lower than the industry average of 23x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Tata Motors

Breaking down the Price-Earnings ratio

A common ratio used for relative valuation is the P/E ratio. 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.

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with 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 TATAMTRDVR, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.

TATAMTRDVR’s P/E of 20.5x is lower than its industry peers (23x), which implies that each dollar of TATAMTRDVR’s earnings is being undervalued by investors. As such, our analysis shows that TATAMTRDVR represents an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that TATAMTRDVR represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to TATAMTRDVR. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with TATAMTRDVR, then TATAMTRDVR’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with TATAMTRDVR, TATAMTRDVR’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing TATAMTRDVR to are fairly valued by the market. If this does not hold, there is a possibility that TATAMTRDVR’s P/E is lower because firms in our peer group are being overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on TATAMTRDVR, the undervaluation of the stock may mean it is a good time to top up on 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 urge you to complete your research by taking a look at the following:

• 1. Future Outlook: What are well-informed industry analysts predicting for TATAMTRDVR’s future growth? Take a look at our free research report of analyst consensus for TATAMTRDVR’s outlook.
• 2. Past Track Record: Has TATAMTRDVR 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 TATAMTRDVR's historicals for more clarity.
• 3. 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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.