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.

Century Textiles and Industries Limited (NSE:CENTURYTEX) trades with a trailing P/E of 22.8, which is higher than the industry average of 20. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, 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 Century Textiles and Industries

Breaking down 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.

P/E Calculation for CENTURYTEX

Price-Earnings Ratio = Price per share ÷ Earnings per share

CENTURYTEX Price-Earnings Ratio = ₹835.25 ÷ ₹36.569 = 22.8x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CENTURYTEX, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since CENTURYTEX’s P/E of 22.8 is higher than its industry peers (20), it means that investors are paying more for each dollar of CENTURYTEX’s earnings. This multiple is a median of profitable companies of 25 Basic Materials companies in IN including Oriental Trimex, Gujarat Sidhee Cement and Saurashtra Cement. You could think of it like this: the market is pricing CENTURYTEX as if it is a stronger company than the average of its industry group.

Assumptions to watch out for

Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to CENTURYTEX. If not, the difference in P/E might be a result of other factors. For example, if Century Textiles and Industries Limited is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to CENTURYTEX may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.