This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between GlaxoSmithkline Pharmaceuticals Limited (BOM:500660)’s fundamentals and stock market performance.
GlaxoSmithkline Pharmaceuticals Limited (BOM:500660) is trading with a trailing P/E of 64.2x, which is higher than the industry average of 25.2x. While 500660 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, 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 GlaxoSmithkline Pharmaceuticals
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 500660
Price per share = ₹2660.45
Earnings per share = ₹41.41
∴ Price-Earnings Ratio = ₹2660.45 ÷ ₹41.41 = 64.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 500660, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
500660’s P/E of 64.2x is higher than its industry peers (25.2x), which implies that each dollar of 500660’s earnings is being overvalued by investors. As such, our analysis shows that 500660 represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your 500660 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 500660. 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 500660, then investors would naturally value 500660 at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with 500660, investors would also value 500660 at a higher price since it is a higher growth investment. Both scenarios would explain why 500660 has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing 500660 to are fairly valued by the market. If this assumption is violated, 500660'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 500660. 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:
- Future Outlook: What are well-informed industry analysts predicting for 500660’s future growth? Take a look at our free research report of analyst consensus for 500660’s outlook.
- Past Track Record: Has 500660 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 500660'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.