In This Article:
I am writing today to help inform people who are new to 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.
Asian Hotels (West) Limited (NSE:AHLWEST) is trading with a trailing P/E of 53.7, which is higher than the industry average of 24. 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.
Check out our latest analysis for Asian Hotels (West)
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 AHLWEST
Price-Earnings Ratio = Price per share ÷ Earnings per share
AHLWEST Price-Earnings Ratio = ₹274.95 ÷ ₹5.124 = 53.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AHLWEST, 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. At 53.7, AHLWEST’s P/E is higher than its industry peers (24). This implies that investors are overvaluing each dollar of AHLWEST’s earnings. This multiple is a median of profitable companies of 25 Hospitality companies in IN including Thomas Cook (India), Dharani Finance and Talwalkars Lifestyles. You could think of it like this: the market is pricing AHLWEST as if it is a stronger company than the average of its industry group.
A few caveats
However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to AHLWEST. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Asian Hotels (West) Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with AHLWEST are not 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.
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 rebalance your portfolio and reduce your holdings in AHLWEST. 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: