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.

Housing Development Finance Corporation Limited (NSE:HDFC) trades with a trailing P/E of 19.3x, which is lower than the industry average of 20x. While HDFC might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

Check out our latest analysis for Housing Development Finance

Breaking down 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 HDFC

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

HDFC Price-Earnings Ratio = ₹1941.65 ÷ ₹100.352 = 19.3x

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 HDFC, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since HDFC’s P/E of 19.3x is lower than its industry peers (20x), it means that investors are paying less than they should for each dollar of HDFC’s earnings. This multiple is a median of profitable companies of 9 Mortgage companies in IN including Indiabulls Housing Finance, Indiabulls Housing Finance and Sahara Housingfina. As such, our analysis shows that HDFC represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy HDFC, 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 HDFC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with HDFC, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing HDFC to are fairly valued by the market. If this does not hold true, HDFC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on HDFC, the undervaluation of the stock may mean it is a good time to top up on 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 urge you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for HDFC’s future growth? Take a look at our free research report of analyst consensus for HDFC’s outlook.

2. Past Track Record: Has HDFC been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of HDFC’s historicals for more clarity.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.