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.
SJVN Limited (NSE:SJVN) trades with a trailing P/E of 9.1x, which is lower than the industry average of 11.5x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. 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 SJVN
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 SJVN
Price per share = ₹26.9
Earnings per share = ₹2.97
∴ Price-Earnings Ratio = ₹26.9 ÷ ₹2.97 = 9.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SJVN, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 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.
SJVN’s P/E of 9.1x is lower than its industry peers (11.5x), which implies that each dollar of SJVN’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 14 Electric Utilities companies in IN including Reliance Infrastructure, Reliance Infrastructure and Tata Power. As such, our analysis shows that SJVN represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy SJVN immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SJVN. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with SJVN, then investors would naturally value SJVN at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SJVN, investors would also value SJVN at a lower price since it is a lower growth investment. Both scenarios would explain why SJVN has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SJVN to are fairly valued by the market. If this does not hold, there is a possibility that SJVN’s P/E is lower because firms in our peer group are being overvalued 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 add more of SJVN to your portfolio. 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Is SJVN’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.
- Past Track Record: Has SJVN 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 SJVN’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.