Is It Time To Sell Tata Consultancy Services Limited (NSE:TCS) Based Off Its PE Ratio?

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 the link between Tata Consultancy Services Limited (NSE:TCS)’s fundamentals and stock market performance.

Tata Consultancy Services Limited (NSE:TCS) is currently trading at a trailing P/E of 27.7x, which is higher than the industry average of 17.3x. While this makes TCS 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. View out our latest analysis for Tata Consultancy Services

Breaking down the P/E ratio

P/E is a popular ratio used for relative valuation. 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.

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 TCS, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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 TCS's P/E of 27.7x is higher than its industry peers (17.3x), it means that investors are paying more than they should for each dollar of TCS's earnings. This multiple is a median of profitable companies of 25 IT companies in IN including Info-Drive Software, Cadsys (India) and Adroit Infotech. As such, our analysis shows that TCS represents an over-priced stock.

A few caveats

Before you jump to the conclusion that TCS 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 TCS. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with TCS, then investors would naturally value TCS at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with TCS, investors would also value TCS at a higher price since it is a higher growth investment. Both scenarios would explain why TCS has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing TCS to are fairly valued by the market. If this assumption does not hold true, TCS’s higher P/E ratio may be 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 TCS. 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:

1. Future Outlook: What are well-informed industry analysts predicting for TCS’s future growth? Take a look at our free research report of analyst consensus for TCS’s outlook.
2. Past Track Record: Has TCS 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 TCS's historicals for more clarity.
3. 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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.