This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Prolife Industries Limited (NSE:PROLIFE) is currently trading at a trailing P/E of 7.4, which is lower than the industry average of 16.6. Although some investors might think this is a real positive, that might change once you understand the assumptions behind the P/E. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for PROLIFE
Price per share = ₹27.2
Earnings per share = ₹3.676
∴ Price-Earnings Ratio = ₹27.2 ÷ ₹3.676 = 7.4x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as PROLIFE, such as size and country of operation. 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.
Since PROLIFE’s P/E of 7.4 is lower than its industry peers (16.6), it means that investors are paying less for each dollar of PROLIFE’s earnings. This multiple is a median of profitable companies of 25 Chemicals companies in IN including Mysore Petro Chemicals, Hindcon Chemicals and Vikas Proppant & Granite. One could put it like this: the market is pricing PROLIFE as if it is a weaker company than the average company in its industry.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two important assertions. The first is that our “similar companies” are actually similar to PROLIFE. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with PROLIFE, then investors would naturally value PROLIFE at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with PROLIFE, investors would also value PROLIFE at a lower price since it is a lower growth investment. Both scenarios would explain why PROLIFE has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing PROLIFE to are fairly valued by the market. If this does not hold, there is a possibility that PROLIFE’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on PROLIFE, the undervaluation of the stock may mean it is a good time to top up on 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 PROLIFE’s future growth? Take a look at our free research report of analyst consensus for PROLIFE’s outlook.
- Past Track Record: Has PROLIFE 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 PROLIFE’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.