In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Nestlé India Limited (NSE:NESTLEIND) is trading with a trailing P/E of 62.2, which is higher than the industry average of 19.1. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Nestlé India
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 NESTLEIND
Price-Earnings Ratio = Price per share ÷ Earnings per share
NESTLEIND Price-Earnings Ratio = ₹9509 ÷ ₹152.883 = 62.2x
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 NESTLEIND, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 62.2, NESTLEIND’s P/E is higher than its industry peers (19.1). This implies that investors are overvaluing each dollar of NESTLEIND’s earnings. This multiple is a median of profitable companies of 25 Food companies in IN including Halder Venture, Magadh Sugar & Energy and Ovobel Foods. You could think of it like this: the market is pricing NESTLEIND as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to NESTLEIND. If not, the difference in P/E might be a result of other factors. For example, if Nestlé India Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with NESTLEIND are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on NESTLEIND, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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: