Precot Meridian Limited (NSEI:PRECOT) trades with a trailing P/E of 42.6x, which is higher than the industry average of 12.5x. While this makes PRECOT 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Precot Meridian
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 PRECOT
Price per share = ₹94.65
Earnings per share = ₹2.224
∴ Price-Earnings Ratio = ₹94.65 ÷ ₹2.224 = 42.6x
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 PRECOT, 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 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 42.6x, PRECOT’s P/E is higher than its industry peers (12.5x). This implies that investors are overvaluing each dollar of PRECOT’s earnings. Therefore, according to this analysis, PRECOT is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your PRECOT shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to PRECOT. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with PRECOT, then PRECOT’s P/E would naturally be higher since investors would reward PRECOT’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with PRECOT, PRECOT’s P/E would again be higher since investors would reward PRECOT’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing PRECOT to are fairly valued by the market. If this does not hold, there is a possibility that PRECOT’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 PRECOT. 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:
1. Financial Health: Is PRECOT’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
2. Past Track Record: Has PRECOT 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 PRECOT’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.