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Tata Motors Limited (NSEI:TATAMTRDVR) is currently trading at a trailing P/E of 18.7x, which is lower than the industry average of 21x. While TATAMTRDVR 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Tata Motors
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 TATAMTRDVR
Price-Earnings Ratio = Price per share ÷ Earnings per share
TATAMTRDVR Price-Earnings Ratio = ₹336.25 ÷ ₹18.026 = 18.7x
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 TATAMTRDVR, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since TATAMTRDVR’s P/E of 18.7x is lower than its industry peers (21x), it means that investors are paying less than they should for each dollar of TATAMTRDVR’s earnings. As such, our analysis shows that TATAMTRDVR represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that TATAMTRDVR is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to TATAMTRDVR. 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 TATAMTRDVR, 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 TATAMTRDVR to are fairly valued by the market. If this is violated, TATAMTRDVR’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of TATAMTRDVR to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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: