In This Article:
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 learn about the link between company’s fundamentals and stock market performance.
Cummins India Limited (NSE:CUMMINSIND) is currently trading at a trailing P/E of 26, which is higher than the industry average of 17.8. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. 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 Cummins India
Demystifying 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.
P/E Calculation for CUMMINSIND
Price-Earnings Ratio = Price per share ÷ Earnings per share
CUMMINSIND Price-Earnings Ratio = ₹668 ÷ ₹25.679 = 26x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CUMMINSIND, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since CUMMINSIND’s P/E of 26 is higher than its industry peers (17.8), it means that investors are paying more for each dollar of CUMMINSIND’s earnings. This multiple is a median of profitable companies of 25 Machinery companies in IN including Revathi Equipment, Bajaj Steel Industries and Envair Electrodyne. You could think of it like this: the market is pricing CUMMINSIND as if it is a stronger company than the average of its industry group.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to CUMMINSIND. If this isn’t the case, the difference in P/E could be due to other factors. For example, Cummins India Limited could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to CUMMINSIND may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.