The content of this article will benefit those of you who are starting to educate yourself about investing in 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.
Sun Pharmaceutical Industries Limited (NSE:SUNPHARMA) is trading with a trailing P/E of 62.5x, which is higher than the industry average of 24.7x. While this makes SUNPHARMA 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as 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 SUNPHARMA
Price per share = ₹562.7
Earnings per share = ₹9
∴ Price-Earnings Ratio = ₹562.7 ÷ ₹9 = 62.5x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SUNPHARMA, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.
Since SUNPHARMA’s P/E of 62.5x is higher than its industry peers (24.7x), it means that investors are paying more than they should for each dollar of SUNPHARMA’s earnings. This multiple is a median of profitable companies of 25 Pharmaceuticals companies in IN including Vasundhara Rasayans, Lasa Supergenerics and Lasa Supergenerics. As such, our analysis shows that SUNPHARMA represents an over-priced stock.
A few caveats
However, before you rush out to sell your SUNPHARMA shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to SUNPHARMA. 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 SUNPHARMA, then SUNPHARMA’s P/E would naturally be higher since investors would reward SUNPHARMA’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with SUNPHARMA, SUNPHARMA’s P/E would again be higher since investors would reward SUNPHARMA’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SUNPHARMA to are fairly valued by the market. If this assumption does not hold true, SUNPHARMA’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to SUNPHARMA. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 SUNPHARMA’s future growth? Take a look at our free research report of analyst consensus for SUNPHARMA’s outlook.
- Past Track Record: Has SUNPHARMA 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 SUNPHARMA’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 pass 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.