This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Hindalco Industries Limited (NSE:HINDALCO) is trading with a trailing P/E of 8.8x, which is lower than the industry average of 13.4x. While this makes HINDALCO appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E 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 HINDALCO
Price-Earnings Ratio = Price per share ÷ Earnings per share
HINDALCO Price-Earnings Ratio = ₹240.35 ÷ ₹27.305 = 8.8x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 HINDALCO, 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 8.8, HINDALCO’s P/E is lower than its industry peers (13.4). This implies that investors are undervaluing each dollar of HINDALCO’s earnings. This multiple is a median of profitable companies of 25 Metals and Mining companies in IN including Bhoruka Aluminium, Golkonda Aluminium Extrusions and Mukand. You can think of it like this: the market is suggesting that HINDALCO is a weaker business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to HINDALCO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with HINDALCO, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing HINDALCO to are fairly valued by the market. If this does not hold, there is a possibility that HINDALCO’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 add more of HINDALCO to your portfolio. 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:
- Future Outlook: What are well-informed industry analysts predicting for HINDALCO’s future growth? Take a look at our free research report of analyst consensus for HINDALCO’s outlook.
- Past Track Record: Has HINDALCO been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of HINDALCO’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.