In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Reliance Capital Limited (NSE:RELCAPITAL) trades with a trailing P/E of 4.3x, which is lower than the industry average of 16.2x. While this makes RELCAPITAL appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, 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 Reliance Capital
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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 RELCAPITAL
Price-Earnings Ratio = Price per share ÷ Earnings per share
RELCAPITAL Price-Earnings Ratio = ₹337.35 ÷ ₹78.211 = 4.3x
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 RELCAPITAL, 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. RELCAPITAL’s P/E of 4.3 is lower than its industry peers (16.2), which implies that each dollar of RELCAPITAL’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Diversified Financial companies in IN including Saraswati Commercial (India), Available Finance and Minolta Finance. You can think of it like this: the market is suggesting that RELCAPITAL 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. Firstly, our peer group contains companies that are similar to RELCAPITAL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with RELCAPITAL, 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 RELCAPITAL to are fairly valued by the market. If this does not hold, there is a possibility that RELCAPITAL’s P/E is lower because our peer group is overvalued by the market.