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.

Reliance Infrastructure Limited (NSE:RELINFRA) is trading with a trailing P/E of 6.4x, which is lower than the industry average of 11.7x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

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Breaking down the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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 RELINFRA

Price-Earnings Ratio = Price per share ÷ Earnings per share

RELINFRA Price-Earnings Ratio = ₹327 ÷ ₹51.191 = 6.4x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to RELINFRA, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since RELINFRA’s P/E of 6.4 is lower than its industry peers (11.7), it means that investors are paying less for each dollar of RELINFRA’s earnings. This multiple is a median of profitable companies of 7 Electric Utilities companies in IN including Tata Power, SJVN and CESC. You can think of it like this: the market is suggesting that RELINFRA is a weaker business than the average comparable company.

Assumptions to watch out for

Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to RELINFRA. 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 RELINFRA, 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 RELINFRA to are fairly valued by the market. If this does not hold, there is a possibility that RELINFRA’s P/E is lower because our peer group is overvalued by the market.