Tata Motors Limited (NYSE:TTM) is trading with a trailing P/E of 24.2x, which is higher than the industry average of 10.8x. While this makes TTM appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Tata Motors
Demystifying 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 TTM
Price-Earnings Ratio = Price per share ÷ Earnings per share
TTM Price-Earnings Ratio = ₹436.15 ÷ ₹18.026 = 24.2x
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 TTM, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 24.2x, TTM’s P/E is higher than its industry peers (10.8x). This implies that investors are overvaluing each dollar of TTM’s earnings. Therefore, according to this analysis, TTM is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your TTM shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to TTM. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with TTM, 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 TTM to are fairly valued by the market. If this does not hold, there is a possibility that TTM’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in TTM. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in TTM, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.