This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Ucal Fuel Systems Limited (NSE:UCALFUEL) is trading with a trailing P/E of 4.5x, which is lower than the industry average of 22.9x. While this makes UCALFUEL appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for UCALFUEL
Price per share = ₹204.15
Earnings per share = ₹45.77
∴ Price-Earnings Ratio = ₹204.15 ÷ ₹45.77 = 4.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to UCALFUEL, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
At 4.5x, UCALFUEL’s P/E is lower than its industry peers (22.9x). This implies that investors are undervaluing each dollar of UCALFUEL’s earnings. This multiple is a median of profitable companies of 23 Auto Components companies in IN including Setco Automotive, Setco Automotive and IST. Therefore, according to this analysis, UCALFUEL is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that UCALFUEL 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 UCALFUEL. 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 UCALFUEL, then UCALFUEL’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 UCALFUEL, UCALFUEL’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 UCALFUEL to are fairly valued by the market. If this does not hold, there is a possibility that UCALFUEL’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 UCALFUEL, 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for UCALFUEL’s future growth? Take a look at our free research report of analyst consensus for UCALFUEL’s outlook.
- Past Track Record: Has UCALFUEL 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 UCALFUEL’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 past 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 email@example.com.