Does Adani Transmissions Limited's (NSE:ADANITRANS) PE Ratio Warrant A Sell?

Adani Transmissions Limited (NSEI:ADANITRANS) is trading with a trailing P/E of 69.5x, which is higher than the industry average of 18.4x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Adani Transmissions

Demystifying the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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.

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 ADANITRANS, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 69.5x, ADANITRANS’s P/E is higher than its industry peers (18.4x). This implies that investors are overvaluing each dollar of ADANITRANS’s earnings. As such, our analysis shows that ADANITRANS represents an over-priced stock.

A few caveats

Before you jump to the conclusion that ADANITRANS should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to ADANITRANS. 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 ADANITRANS, then investors would naturally value ADANITRANS at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with ADANITRANS, investors would also value ADANITRANS at a higher price since it is a higher growth investment. Both scenarios would explain why ADANITRANS has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ADANITRANS to are fairly valued by the market. If this assumption does not hold true, ADANITRANS’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.

What this means for you:

Since you may have already conducted your due diligence on ADANITRANS, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined 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:

1. Future Outlook: What are well-informed industry analysts predicting for ADANITRANS’s future growth? Take a look at our free research report of analyst consensus for ADANITRANS’s outlook.

2. Financial Health: Is ADANITRANS’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.

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.