This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Uravi T and Wedge Lamps Limited (NSE:URAVI) trades with a trailing P/E of 18.5x, which is lower than the industry average of 20.6x. While this makes URAVI 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 Uravi T and Wedge Lamps
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 URAVI
Price-Earnings Ratio = Price per share ÷ Earnings per share
URAVI Price-Earnings Ratio = ₹102 ÷ ₹5.51 = 18.5x
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 URAVI, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since URAVI’s P/E of 18.5 is lower than its industry peers (20.6), it means that investors are paying less for each dollar of URAVI’s earnings. This multiple is a median of profitable companies of 25 Auto Components companies in IN including IST, Ucal Fuel Systems and Ucal Fuel Systems. One could put it like this: the market is pricing URAVI 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 URAVI. 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 URAVI, 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 URAVI to are fairly valued by the market. If this does not hold true, URAVI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.