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.
Gujarat Raffia Industries Limited (NSE:GUJRAFIA) is currently trading at a trailing P/E of 11.9x, which is lower than the industry average of 14.9x. While this makes GUJRAFIA 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.
See our latest analysis for Gujarat Raffia Industries
Breaking down 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 GUJRAFIA
Price-Earnings Ratio = Price per share ÷ Earnings per share
GUJRAFIA Price-Earnings Ratio = ₹21.5 ÷ ₹1.811 = 11.9x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to GUJRAFIA, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 11.9, GUJRAFIA’s P/E is lower than its industry peers (14.9). This implies that investors are undervaluing each dollar of GUJRAFIA’s earnings. 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. One could put it like this: the market is pricing GUJRAFIA as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to GUJRAFIA, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with GUJRAFIA, 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 GUJRAFIA to are fairly valued by the market. If this is violated, GUJRAFIA’s P/E may be lower than its peers as they are actually overvalued by investors.