This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Caplin Point Laboratories Limited (NSE:CAPPL) trades with a trailing P/E of 21.1x, which is lower than the industry average of 22.4x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Caplin Point Laboratories
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 CAPPL
Price-Earnings Ratio = Price per share ÷ Earnings per share
CAPPL Price-Earnings Ratio = ₹407.1 ÷ ₹19.293 = 21.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CAPPL, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. CAPPL’s P/E of 21.1 is lower than its industry peers (22.4), which implies that each dollar of CAPPL’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Pharmaceuticals companies in IN including Vasundhara Rasayans, Vivimed Labs and Beryl Drugs. One could put it like this: the market is pricing CAPPL as if it is a weaker company than the average company in its industry.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to CAPPL, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CAPPL, 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 CAPPL to are fairly valued by the market. If this is violated, CAPPL’s P/E may be lower than its peers as they are actually overvalued by investors.