Should You Be Tempted To Sell SP Apparels Limited (BOM:540048) Because Of Its PE Ratio?

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 better understand how you can grow your money by investing in SP Apparels Limited (BOM:540048).

SP Apparels Limited (BOM:540048) trades with a trailing P/E of 17.4x, which is higher than the industry average of 17.2x. While this makes 540048 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View out our latest analysis for S.P. Apparels

Demystifying the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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.

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 540048, 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 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.

540048’s P/E of 17.4x is higher than its industry peers (17.2x), which implies that each dollar of 540048’s earnings is being overvalued by investors. As such, our analysis shows that 540048 represents an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that 540048 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 540048. 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 540048, then 540048’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 540048. In this case, 540048’s P/E would be higher since investors would also reward 540048’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 540048 to are fairly valued by the market. If this assumption does not hold true, 540048’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.

What this means for you:

Since you may have already conducted your due diligence on 540048, the overvaluation of the stock may mean it is a good time to reduce 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:

1. Future Outlook: What are well-informed industry analysts predicting for 540048’s future growth? Take a look at our free research report of analyst consensus for 540048’s outlook.
2. Past Track Record: Has 540048 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 540048'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.