This article is intended for those of you who are at the beginning of your investing journey and want to better understand how you can grow your money by investing in Dr Reddy’s Laboratories Limited (BOM:500124).
Dr Reddy’s Laboratories Limited (BOM:500124) trades with a trailing P/E of 35.2x, which is higher than the industry average of 25x. While this makes 500124 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View out our latest analysis for Dr. Reddy’s Laboratories
Breaking down the Price-Earnings 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 500124
Price per share = ₹2081.45
Earnings per share = ₹59.13
∴ Price-Earnings Ratio = ₹2081.45 ÷ ₹59.13 = 35.2x
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 500124, 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 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 35.2x, 500124’s P/E is higher than its industry peers (25x). This implies that investors are overvaluing each dollar of 500124’s earnings. Therefore, according to this analysis, 500124 is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that 500124 should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to 500124. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with 500124, then 500124’s P/E would naturally be higher since investors would reward 500124’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with 500124, 500124’s P/E would again be higher since investors would reward 500124’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing 500124 to are fairly valued by the market. If this does not hold, there is a possibility that 500124’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 500124. 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:
- Future Outlook: What are well-informed industry analysts predicting for 500124’s future growth? Take a look at our free research report of analyst consensus for 500124’s outlook.
- Past Track Record: Has 500124 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 500124’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.