The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
ICICI Bank Limited (NSE:ICICIBANK) is currently trading at a trailing P/E of 26.9, which is higher than the industry average of 21.5. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, 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
A common ratio used for relative valuation is the P/E ratio. 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 ICICIBANK
Price-Earnings Ratio = Price per share ÷ Earnings per share
ICICIBANK Price-Earnings Ratio = ₹322.9 ÷ ₹12.018 = 26.9x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ICICIBANK, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. ICICIBANK’s P/E of 26.9 is higher than its industry peers (21.5), which implies that each dollar of ICICIBANK’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 18 Banks companies in IN including Karnataka Bank, Vijaya Bank and South Indian Bank. You could think of it like this: the market is pricing ICICIBANK as if it is a stronger company than the average of its industry group.
A few caveats
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to ICICIBANK. If this isn’t the case, the difference in P/E could be due to other factors. For example, if ICICI Bank Limited is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to ICICIBANK may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to ICICIBANK. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 ICICIBANK’s future growth? Take a look at our free research report of analyst consensus for ICICIBANK’s outlook.
- Past Track Record: Has ICICIBANK 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 ICICIBANK’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.