The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Fifth Third Bancorp (NASDAQ:FITB) is trading with a trailing P/E of 7.6x, which is lower than the industry average of 16.3x. While FITB might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the Price-Earnings 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 FITB
Price-Earnings Ratio = Price per share ÷ Earnings per share
FITB Price-Earnings Ratio = $29.45 ÷ $3.871 = 7.6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FITB, 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 7.6x, FITB’s P/E is lower than its industry peers (16.3x). This implies that investors are undervaluing each dollar of FITB’s earnings. This multiple is a median of profitable companies of 25 Banks companies in US including Great Basin Financial, Mercantil Servicios Financieros C.A and CIB Marine Bancshares. Therefore, according to this analysis, FITB is an under-priced stock.
A few caveats
However, before you rush out to buy FITB, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to FITB. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with FITB, 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 FITB to are fairly valued by the market. If this does not hold, there is a possibility that FITB’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
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 FITB. 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. 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 FITB’s future growth? Take a look at our free research report of analyst consensus for FITB’s outlook.
- Past Track Record: Has FITB 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 FITB’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.