Central Valley Community Bancorp (NASDAQ:CVCY) is trading with a trailing P/E of 17.4x, which is lower than the industry average of 18.6x. While this makes CVCY 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. Check out our latest analysis for Central Valley Community Bancorp
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 CVCY
Price-Earnings Ratio = Price per share ÷ Earnings per share
CVCY Price-Earnings Ratio = 21.71 ÷ 1.249 = 17.4x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CVCY, 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. At 17.4x, CVCY’s P/E is lower than its industry peers (18.6x). This implies that investors are undervaluing each dollar of CVCY’s earnings. As such, our analysis shows that CVCY represents an under-priced stock.
A few caveats
However, before you rush out to buy CVCY, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to CVCY, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CVCY, 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 CVCY to are fairly valued by the market. If this does not hold, there is a possibility that CVCY’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to CVCY. 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.
Are you a potential investor? If you are considering investing in CVCY, 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 Central Valley Community Bancorp 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.