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Should You Be Tempted To Sell Bajaj Finance Limited (NSE:BAJFINANCE) At Its Current PE Ratio?

Bajaj Finance Limited (NSEI:BAJFINANCE) is trading with a trailing P/E of 55.7x, which is higher than the industry average of 28.1x. While this makes BAJFINANCE 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. See our latest analysis for Bajaj Finance

Breaking down the Price-Earnings ratio

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

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for BAJFINANCE

Price per share = ₹1893.8

Earnings per share = ₹34.008

∴ Price-Earnings Ratio = ₹1893.8 ÷ ₹34.008 = 55.7x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 BAJFINANCE, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 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 55.7x, BAJFINANCE’s P/E is higher than its industry peers (28.1x). This implies that investors are overvaluing each dollar of BAJFINANCE’s earnings. Therefore, according to this analysis, BAJFINANCE is an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that BAJFINANCE 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 BAJFINANCE. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with BAJFINANCE, then investors would naturally value BAJFINANCE at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with BAJFINANCE, investors would also value BAJFINANCE at a higher price since it is a higher growth investment. Both scenarios would explain why BAJFINANCE has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing BAJFINANCE to are fairly valued by the market. If this assumption is violated, BAJFINANCE’s P/E may be higher than its peers because its peers are actually undervalued by investors.

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 BAJFINANCE. 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 urge you to complete your research by taking a look at the following:

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