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Rico Auto Industries Limited (NSEI:RICOAUTO) trades with a trailing P/E of 26.4x, which is lower than the industry average of 28.8x. 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Rico Auto Industries
Demystifying 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. 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.
P/E Calculation for RICOAUTO
Price-Earnings Ratio = Price per share ÷ Earnings per share
RICOAUTO Price-Earnings Ratio = ₹83.3 ÷ ₹3.158 = 26.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to RICOAUTO, 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. At 26.4x, RICOAUTO’s P/E is lower than its industry peers (28.8x). This implies that investors are undervaluing each dollar of RICOAUTO’s earnings. As such, our analysis shows that RICOAUTO represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy RICOAUTO, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to RICOAUTO, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with RICOAUTO, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing RICOAUTO to are fairly valued by the market. If this does not hold true, RICOAUTO’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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.