In This Article:
Tamilnadu Petroproducts Limited (NSEI:TNPETRO) trades with a trailing P/E of 41x, which is higher than the industry average of 23.1x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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 Tamilnadu Petroproducts
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 TNPETRO
Price-Earnings Ratio = Price per share ÷ Earnings per share
TNPETRO Price-Earnings Ratio = ₹51.4 ÷ ₹1.255 = 41x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to TNPETRO, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 41x, TNPETRO’s P/E is higher than its industry peers (23.1x). This implies that investors are overvaluing each dollar of TNPETRO’s earnings. As such, our analysis shows that TNPETRO represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your TNPETRO shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to TNPETRO, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with TNPETRO, 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 TNPETRO to are fairly valued by the market. If this does not hold, there is a possibility that TNPETRO’s P/E is lower because our peer group is overvalued by the market.
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 TNPETRO. 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 highly recommend you to complete your research by taking a look at the following: