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.
Eimco Elecon (India) Limited (NSE:EIMCOELECO) is trading with a trailing P/E of 12.2x, which is lower than the industry average of 26.5x. While this makes EIMCOELECO 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 explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E 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 EIMCOELECO
Price per share = ₹377.7
Earnings per share = ₹30.916
∴ Price-Earnings Ratio = ₹377.7 ÷ ₹30.916 = 12.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to EIMCOELECO, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 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.
At 12.2x, EIMCOELECO’s P/E is lower than its industry peers (26.5x). This implies that investors are undervaluing each dollar of EIMCOELECO’s earnings. This multiple is a median of profitable companies of 23 Machinery companies in IN including Bajaj Steel Industries, Envair Electrodyne and T & I Global. As such, our analysis shows that EIMCOELECO represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy EIMCOELECO, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to EIMCOELECO. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with EIMCOELECO, then EIMCOELECO’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 EIMCOELECO, EIMCOELECO’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 EIMCOELECO to are fairly valued by the market. If this assumption does not hold true, EIMCOELECO’s lower P/E ratio may be 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 EIMCOELECO, 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 EIMCOELECO’s future growth? Take a look at our free research report of analyst consensus for EIMCOELECO’s outlook.
- Past Track Record: Has EIMCOELECO 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 EIMCOELECO’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 firstname.lastname@example.org.