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.
GAIL (India) Limited (NSE:GAIL) is trading with a trailing P/E of 15.6, which is close to the industry average of 15.9. While this makes GAIL appear like a great stock to buy, 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.
What you need to know about 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 GAIL
Price-Earnings Ratio = Price per share ÷ Earnings per share
GAIL Price-Earnings Ratio = ₹332.05 ÷ ₹21.26 = 15.6x
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 GAIL, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. GAIL (India) Limited (NSE:GAIL) is currently trading at a trailing P/E of 15.6, which is close to the industry average of 15.9. This multiple is a median of profitable companies of 4 Gas Utilities companies in IN including Gujarat State Petronet, Mahanagar Gas and Indraprastha Gas. You can think of it like this: the market is suggesting that GAIL has similar prospects to its peers in the same industry.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to GAIL. 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 GAIL, 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 GAIL to are fairly valued by the market. If this does not hold true, GAIL’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 GAIL 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 GAIL’s future growth? Take a look at our free research report of analyst consensus for GAIL’s outlook.
- Past Track Record: Has GAIL 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 GAIL’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.