IDFC Limited (NSEI:IDFC) is trading with a trailing P/E of 11.6x, which is lower than the industry average of 17x. While IDFC 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. View our latest analysis for IDFC
Demystifying 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 IDFC
Price-Earnings Ratio = Price per share ÷ Earnings per share
IDFC Price-Earnings Ratio = ₹52.3 ÷ ₹4.521 = 11.6x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as IDFC, 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. IDFC’s P/E of 11.6x is lower than its industry peers (17x), which implies that each dollar of IDFC’s earnings is being undervalued by investors. Therefore, according to this analysis, IDFC is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy IDFC, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to IDFC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with IDFC, 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 IDFC to are fairly valued by the market. If this does not hold, there is a possibility that IDFC’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.