Bharat Heavy Electricals Limited (NSEI:BHEL) is currently trading at a trailing P/E of 69.8x, which is higher than the industry average of 25.9x. While this makes BHEL appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Bharat Heavy Electricals
Breaking down 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. 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 BHEL
Price-Earnings Ratio = Price per share ÷ Earnings per share
BHEL Price-Earnings Ratio = ₹86.9 ÷ ₹1.245 = 69.8x
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 BHEL, 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. BHEL’s P/E of 69.8x is higher than its industry peers (25.9x), which implies that each dollar of BHEL’s earnings is being overvalued by investors. Therefore, according to this analysis, BHEL is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your BHEL shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to BHEL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with BHEL, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing BHEL to are fairly valued by the market. If this does not hold, there is a possibility that BHEL’s P/E is lower because our peer group is overvalued by the market.
To help readers see pass 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.