ICICI Bank Limited (NSEI:ICICIBANK) is trading with a trailing P/E of 17.5x, which is lower than the industry average of 18.5x. While this makes ICICIBANK appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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. View our latest analysis for ICICI Bank

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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 ICICIBANK

Price-Earnings Ratio = Price per share ÷ Earnings per share

ICICIBANK Price-Earnings Ratio = ₹278.35 ÷ ₹15.918 = 17.5x

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 ICICIBANK, 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. ICICIBANK’s P/E of 17.5x is lower than its industry peers (18.5x), which implies that each dollar of ICICIBANK’s earnings is being undervalued by investors. Therefore, according to this analysis, ICICIBANK is an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy ICICIBANK immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to ICICIBANK. 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 ICICIBANK, 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 ICICIBANK to are fairly valued by the market. If this does not hold, there is a possibility that ICICIBANK’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.