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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.
Eimco Elecon (India) Limited (NSE:EIMCOELECO) is trading with a trailing P/E of 10.4x, which is lower than the industry average of 17.8x. While EIMCOELECO 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
See our latest analysis for Eimco Elecon (India)
What you need to know about 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 EIMCOELECO
Price-Earnings Ratio = Price per share ÷ Earnings per share
EIMCOELECO Price-Earnings Ratio = ₹320 ÷ ₹30.916 = 10.4x
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 EIMCOELECO, 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 EIMCOELECO’s P/E of 10.4 is lower than its industry peers (17.8), it means that investors are paying less for each dollar of EIMCOELECO’s earnings. This multiple is a median of profitable companies of 24 Machinery companies in IN including Revathi Equipment, Bajaj Steel Industries and Envair Electrodyne. You can think of it like this: the market is suggesting that EIMCOELECO is a weaker business than the average comparable company.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to EIMCOELECO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with EIMCOELECO, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing EIMCOELECO to are fairly valued by the market. If this is violated, EIMCOELECO’s P/E may be lower than its peers as they are actually overvalued by investors.