Should You Be Tempted To Sell Avenue Supermarts Limited (NSE:DMART) Because Of Its PE Ratio?

Avenue Supermarts Limited (NSEI:DMART) trades with a trailing P/E of 137.4x, which is higher than the industry average of 35.3x. While this makes DMART 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 our latest analysis for Avenue Supermarts

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in 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.

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 DMART, such as company lifetime and products sold. 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.

DMART’s P/E of 137.4x is higher than its industry peers (35.3x), which implies that each dollar of DMART’s earnings is being overvalued by investors. As such, our analysis shows that DMART represents an over-priced stock.

A few caveats

However, before you rush out to sell your DMART shares, 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 DMART. 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 DMART, then DMART’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 DMART. In this case, DMART’s P/E would be higher since investors would also reward DMART’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DMART to are fairly valued by the market. If this does not hold, there is a possibility that DMART’s P/E is higher 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 DMART, 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 urge you to complete your research by taking a look at the following:

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