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.
Aurangabad Distillery Limited (NSE:AURDIS) is currently trading at a trailing P/E of 7.9x, which is lower than the industry average of 23x. While AURDIS might seem like an attractive stock to buy, 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 Aurangabad Distillery
Breaking down the Price-Earnings 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.
P/E Calculation for AURDIS
Price-Earnings Ratio = Price per share ÷ Earnings per share
AURDIS Price-Earnings Ratio = ₹29 ÷ ₹3.666 = 7.9x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 AURDIS, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since AURDIS’s P/E of 7.9 is lower than its industry peers (23), it means that investors are paying less for each dollar of AURDIS’s earnings. This multiple is a median of profitable companies of 11 Beverage companies in IN including Pincon Spirit, G.M.Breweries and Associated Alcohols & Breweries. You can think of it like this: the market is suggesting that AURDIS is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to AURDIS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with AURDIS, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing AURDIS to are fairly valued by the market. If this is violated, AURDIS’s P/E may be lower than its peers as they are actually overvalued by investors.