VRL Logistics Limited (NSEI:VRLLOG) trades with a trailing P/E of 41.1x, which is higher than the industry average of 18.5x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for VRL Logistics

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for relative valuation. 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 VRLLOG

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

VRLLOG Price-Earnings Ratio = ₹400.55 ÷ ₹9.753 = 41.1x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to VRLLOG, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 41.1x, VRLLOG’s P/E is higher than its industry peers (18.5x). This implies that investors are overvaluing each dollar of VRLLOG’s earnings. Therefore, according to this analysis, VRLLOG is an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that VRLLOG should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to VRLLOG, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with VRLLOG, 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 VRLLOG to are fairly valued by the market. If this does not hold true, VRLLOG’s lower P/E ratio may be because firms in our peer group are 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 VRLLOG. 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: