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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
SJVN Limited (NSE:SJVN) is currently trading at a trailing P/E of 9.8x, which is lower than the industry average of 11.5x. While SJVN 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 SJVN
Breaking down the P/E 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 SJVN
Price-Earnings Ratio = Price per share ÷ Earnings per share
SJVN Price-Earnings Ratio = ₹29.1 ÷ ₹2.961 = 9.8x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 SJVN, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 9.8, SJVN’s P/E is lower than its industry peers (11.5). This implies that investors are undervaluing each dollar of SJVN’s earnings. This multiple is a median of profitable companies of 7 Electric Utilities companies in IN including Tata Power, Reliance Infrastructure and India Grid Trust. One could put it like this: the market is pricing SJVN as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to SJVN. 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 SJVN, 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 SJVN to are fairly valued by the market. If this is violated, SJVN’s P/E may be lower than its peers as they are actually overvalued by investors.