Broadway Financial Corporation (NASDAQ:BYFC) trades with a trailing P/E of 13.9x, which is lower than the industry average of 23.6x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Broadway Financial
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for BYFC
Price per share = 2.14
Earnings per share = 0.154
∴ Price-Earnings Ratio = 2.14 ÷ 0.154 = 13.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to BYFC, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
Since BYFC's P/E of 13.9x is lower than its industry peers (23.6x), it means that investors are paying less than they should for each dollar of BYFC's earnings. Therefore, according to this analysis, BYFC is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy BYFC immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to BYFC. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with BYFC, then investors would naturally value BYFC at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with BYFC, investors would also value BYFC at a lower price since it is a lower growth investment. Both scenarios would explain why BYFC has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing BYFC to are fairly valued by the market. If this assumption is violated, BYFC's P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on BYFC, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If you are considering investing in BYFC, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Broadway Financial for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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.