This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Aarvi Encon Limited (NSE:AARVI) is trading with a trailing P/E of 8.8x, which is lower than the industry average of 13.1x. While this makes AARVI appear like a great stock to buy, 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 Aarvi Encon
What you need to know about 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. 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 AARVI
Price-Earnings Ratio = Price per share ÷ Earnings per share
AARVI Price-Earnings Ratio = ₹53 ÷ ₹6.044 = 8.8x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to AARVI, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since AARVI’s P/E of 8.8 is lower than its industry peers (13.1), it means that investors are paying less for each dollar of AARVI’s earnings. This multiple is a median of profitable companies of 18 Professional Services companies in IN including Samtel India, Provestment Services and Choksi Laboratories. You can think of it like this: the market is suggesting that AARVI is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AARVI, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with AARVI, 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 AARVI to are fairly valued by the market. If this is violated, AARVI’s P/E may be lower than its peers as they are actually overvalued by investors.