In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Swaraj Engines Limited (NSE:SWARAJENG) is trading with a trailing P/E of 19.9, which is higher than the industry average of 17.6. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
View our latest analysis for Swaraj Engines
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 SWARAJENG
Price-Earnings Ratio = Price per share ÷ Earnings per share
SWARAJENG Price-Earnings Ratio = ₹1320 ÷ ₹66.27 = 19.9x
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 SWARAJENG, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. SWARAJENG’s P/E of 19.9 is higher than its industry peers (17.6), which implies that each dollar of SWARAJENG’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Machinery companies in IN including Revathi Equipment, Bajaj Steel Industries and Envair Electrodyne. You could think of it like this: the market is pricing SWARAJENG as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to SWARAJENG. If not, the difference in P/E might be a result of other factors. For example, Swaraj Engines Limited could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with SWARAJENG 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:
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 SWARAJENG. 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: