Tata Motors Limited (NYSE: TTM) shares currently trade at 15.2x trailing earnings which is lower than the Consumer Discretionary sector median of 18.6x. While this makes TTM look like a stock to add to your portfolio, equity investors might change their mind after taking a closer look at the assumptions behind the P/E ratio. In this article, I define how to calculate a P/E multiple and what to keep an eye out for when applying it in a comparable companies analysis.
Tata Comparable Companies Analysis
A comparable companies analysis, also known as a multiples valuation, determines the value of a subject company by benchmarking its financial performance against similar public companies or peers. We can conclude if a company looks undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation ratios.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare Tata’s P/E ratio to its peer group that includes Fuji Heavy Industries, Ltd. (NYSE: FUJHY), AutoZone, Inc. (NYSE: AZO), Ford Motor Company (NYSE: F) and Fiat Chrysler Automobiles N.V. (NYSE: FCAU).
Since Tata’s P/E of 15.2x is higher than the median of its peers (9.4x), it means that investors are paying more than they should for each dollar of TTM’s earnings. As such, our analysis shows that TTM represents an overvalued stock. In fact, finbox.io’s P/E Multiple Modelcalculates a fair value of roughly $17.00 per share which implies around 30.5% downside.
I selected a fair multiple of 10.5x in my analysis by averaging Tata’s current P/E ratio with its peer group.
Are Peers Really Comparable?
Before concluding that Tata should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to Tata, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare Tata with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
However, if the second assumption does not hold true, Tata’s higher multiple may be because firms in our peer group are being undervalued by the market.
How This Impacts Shareholders
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to TTM. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on Tata by taking a look at the following:
Valuation Metrics: how much upside do shares of Tata have based on the Ben Graham Formula? Take a look at our Ben Graham Formula data explorer which also compares the company’s upside to its peers.
Risk Metrics: what is Tata’s Altman Z score? It’s a famous formula used to predict the probability that a firm will go into bankruptcy within two years. View the company’s Altman Z score here.
Efficiency Metrics: how much free cash flow does Tata generate as a percentage of total sales? Has it been increasing or decreasing over time? Review the firm’s free cash flow margin here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.