Dr. Reddy's Laboratories Limited's (NSE:DRREDDY) price-to-earnings (or "P/E") ratio of 18.7x might make it look like a buy right now compared to the market in India, where around half of the companies have P/E ratios above 28x and even P/E's above 54x are quite common. However, the P/E might be low for a reason and it requires further investigation to determine if it's justified.
Recent times haven't been advantageous for Dr. Reddy's Laboratories as its earnings have been rising slower than most other companies. The P/E is probably low because investors think this lacklustre earnings performance isn't going to get any better. If this is the case, then existing shareholders will probably struggle to get excited about the future direction of the share price.
See our latest analysis for Dr. Reddy's Laboratories
What Are Growth Metrics Telling Us About The Low P/E?
There's an inherent assumption that a company should underperform the market for P/E ratios like Dr. Reddy's Laboratories' to be considered reasonable.
Taking a look back first, we see that there was hardly any earnings per share growth to speak of for the company over the past year. However, a few strong years before that means that it was still able to grow EPS by an impressive 90% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been superb for the company.
Looking ahead now, EPS is anticipated to slump, contracting by 2.2% per annum during the coming three years according to the analysts following the company. With the market predicted to deliver 19% growth per year, that's a disappointing outcome.
In light of this, it's understandable that Dr. Reddy's Laboratories' P/E would sit below the majority of other companies. However, shrinking earnings are unlikely to lead to a stable P/E over the longer term. Even just maintaining these prices could be difficult to achieve as the weak outlook is weighing down the shares.
The Final Word
We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.
As we suspected, our examination of Dr. Reddy's Laboratories' analyst forecasts revealed that its outlook for shrinking earnings is contributing to its low P/E. At this stage investors feel the potential for an improvement in earnings isn't great enough to justify a higher P/E ratio. Unless these conditions improve, they will continue to form a barrier for the share price around these levels.
Plus, you should also learn about this 1 warning sign we've spotted with Dr. Reddy's Laboratories.
If these risks are making you reconsider your opinion on Dr. Reddy's Laboratories, explore our interactive list of high quality stocks to get an idea of what else is out there.
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