I am writing today to help inform people who are new to 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.
Lloyds Steels Industries Limited (NSE:LLOYDSTEEL) is trading with a trailing P/E of 19.5, which is higher than the industry average of 11.4. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what other factors to keep in mind.
Demystifying 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 LLOYDSTEEL
Price per share = ₹1.15
Earnings per share = ₹0.0590
∴ Price-Earnings Ratio = ₹1.15 ÷ ₹0.0590 = 19.5x
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 LLOYDSTEEL, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since LLOYDSTEEL’s P/E of 19.5 is higher than its industry peers (11.4), it means that investors are paying more for each dollar of LLOYDSTEEL’s earnings. This multiple is a median of profitable companies of 25 Metals and Mining companies in IN including Bhoruka Aluminium, Golkonda Aluminium Extrusions and Mukand. You could also say that the market is suggesting that LLOYDSTEEL has a stronger business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to LLOYDSTEEL. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Lloyds Steels Industries Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with LLOYDSTEEL are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on LLOYDSTEEL, 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:
- Future Outlook: What are well-informed industry analysts predicting for LLOYDSTEEL’s future growth? Take a look at our free research report of analyst consensus for LLOYDSTEEL’s outlook.
- Past Track Record: Has LLOYDSTEEL 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 LLOYDSTEEL’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.