In This Article:
I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Shakti Pumps (India) Limited (NSE:SHAKTIPUMP) trades with a trailing P/E of 16x, which is lower than the industry average of 17.8x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Shakti Pumps (India)
Breaking down the Price-Earnings 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 SHAKTIPUMP
Price-Earnings Ratio = Price per share ÷ Earnings per share
SHAKTIPUMP Price-Earnings Ratio = ₹311.05 ÷ ₹19.449 = 16x
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 SHAKTIPUMP, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 16, SHAKTIPUMP’s P/E is lower than its industry peers (17.8). This implies that investors are undervaluing each dollar of SHAKTIPUMP’s earnings. This multiple is a median of profitable companies of 25 Machinery companies in IN including Revathi Equipment, Bajaj Steel Industries and Envair Electrodyne. One could put it like this: the market is pricing SHAKTIPUMP as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
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 SHAKTIPUMP. 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 SHAKTIPUMP, 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 SHAKTIPUMP to are fairly valued by the market. If this is violated, SHAKTIPUMP’s P/E may be lower than its peers as they are actually overvalued by investors.