Indowind Energy Limited (NSEI:INDOWIND) is trading with a trailing P/E of 12.7x, which is higher than the industry average of 10.2x. While INDOWIND might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, 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 Indowind Energy

What you need to know about the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 INDOWIND

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

INDOWIND Price-Earnings Ratio = ₹7.92 ÷ ₹0.625 = 12.7x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to INDOWIND, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since INDOWIND’s P/E of 12.7x is higher than its industry peers (10.2x), it means that investors are paying more than they should for each dollar of INDOWIND’s earnings. As such, our analysis shows that INDOWIND represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your INDOWIND shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to INDOWIND. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with INDOWIND, 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 INDOWIND to are fairly valued by the market. If this is violated, INDOWIND’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in INDOWIND. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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: