In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
The New India Assurance Company Limited (NSE:NIACL) is trading with a trailing P/E of 15.2x, which is lower than the industry average of 31.8x. While this makes NIACL appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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.
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What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 NIACL
Price-Earnings Ratio = Price per share ÷ Earnings per share
NIACL Price-Earnings Ratio = ₹206 ÷ ₹13.528 = 15.2x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to NIACL, 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. At 15.2, NIACL’s P/E is lower than its industry peers (31.8). This implies that investors are undervaluing each dollar of NIACL’s earnings. This multiple is a median of profitable companies of 7 Insurance companies in IN including General Insurance of India, ICICI Prudential Life Insurance and Bajaj Finserv. You can think of it like this: the market is suggesting that NIACL is a weaker business than the average comparable company.
A few caveats
However, 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 NIACL, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with NIACL, 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 NIACL to are fairly valued by the market. If this does not hold true, NIACL’s lower P/E ratio may be because firms in our peer group are overvalued by the market.