This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Cosmo Films Limited (NSE:COSMOFILMS) trades with a trailing P/E of 7.6x, which is lower than the industry average of 16.1x. While this makes COSMOFILMS appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Cosmo Films
Breaking down the Price-Earnings 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 COSMOFILMS
Price-Earnings Ratio = Price per share ÷ Earnings per share
COSMOFILMS Price-Earnings Ratio = ₹258 ÷ ₹34.007 = 7.6x
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 COSMOFILMS, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. COSMOFILMS’s P/E of 7.6 is lower than its industry peers (16.1), which implies that each dollar of COSMOFILMS’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Packaging companies in IN including Universal Prime Aluminium, SMVD Poly Pack and Everest Kanto Cylinder. You can think of it like this: the market is suggesting that COSMOFILMS is a weaker business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to COSMOFILMS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with COSMOFILMS, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing COSMOFILMS to are fairly valued by the market. If this does not hold true, COSMOFILMS’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on COSMOFILMS, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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: