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.

PI Industries Limited (NSE:PIIND) is currently trading at a trailing P/E of 28.4, which is higher than the industry average of 16.6. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, 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 PI Industries

Demystifying 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 PIIND

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

PIIND Price-Earnings Ratio = ₹759 ÷ ₹26.723 = 28.4x

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 PIIND, 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. Since PIIND’s P/E of 28.4 is higher than its industry peers (16.6), it means that investors are paying more for each dollar of PIIND’s earnings. This multiple is a median of profitable companies of 25 Chemicals companies in IN including Mysore Petro Chemicals, Hindcon Chemicals and Vikas Proppant & Granite. You could think of it like this: the market is pricing PIIND as if it is a stronger company than the average of its industry group.

A few caveats

However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to PIIND. If not, the difference in P/E might be a result of other factors. For example, if PI Industries Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with PIIND are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.

What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to PIIND. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 highly recommend you to complete your research by taking a look at the following: