Carolina Financial Corporation (NASDAQ:CARO) is trading with a trailing P/E of 19.4x, which is higher than the industry average of 17.8x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for CARO
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 CARO
Price-Earnings Ratio = Price per share ÷ Earnings per share
CARO Price-Earnings Ratio = 37.07 ÷ 1.913 = 19.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 CARO, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. CARO’s P/E of 19.4x is higher than its industry peers (17.8x), which implies that each dollar of CARO’s earnings is being overvalued by investors. Therefore, according to this analysis, CARO is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that CARO should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to CARO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CARO, 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 CARO to are fairly valued by the market. If this does not hold, there is a possibility that CARO’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on CARO, the overvaluation of the stock may mean it is a good time to reduce 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 CARO, 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 Carolina 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.