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This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Khaitan (India) Limited (NSE:KHAITANLTD) is trading with a trailing P/E of 11.1x, which is lower than the industry average of 20.1x. While this makes KHAITANLTD 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 Khaitan (India)
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 KHAITANLTD
Price-Earnings Ratio = Price per share ÷ Earnings per share
KHAITANLTD Price-Earnings Ratio = ₹43.4 ÷ ₹3.9 = 11.1x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as KHAITANLTD, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 11.1, KHAITANLTD’s P/E is lower than its industry peers (20.1). This implies that investors are undervaluing each dollar of KHAITANLTD’s earnings. This multiple is a median of profitable companies of 25 Food companies in IN including Halder Venture, Ovobel Foods and Kwality. You can think of it like this: the market is suggesting that KHAITANLTD is a weaker business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to KHAITANLTD, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with KHAITANLTD, 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 KHAITANLTD to are fairly valued by the market. If this is violated, KHAITANLTD’s P/E may be lower than its peers as they are actually overvalued by investors.