I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Meghmani Organics Limited (NSE:MEGH) is trading with a trailing P/E of 11x, which is lower than the industry average of 18.5x. While MEGH might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 MEGH
Price-Earnings Ratio = Price per share ÷ Earnings per share
MEGH Price-Earnings Ratio = ₹87.65 ÷ ₹7.949 = 11x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to MEGH, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 11, MEGH’s P/E is lower than its industry peers (18.5). This implies that investors are undervaluing each dollar of MEGH’s earnings. This multiple is a median of profitable companies of 25 Chemicals companies in IN including Anil, Sysco Industries and Mysore Petro Chemicals. One could put it like this: the market is pricing MEGH as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to MEGH. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with MEGH, 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 MEGH to are fairly valued by the market. If this does not hold true, MEGH’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 add more of MEGH 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for MEGH’s future growth? Take a look at our free research report of analyst consensus for MEGH’s outlook.
- Past Track Record: Has MEGH 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 MEGH’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 email@example.com.