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.
First Financial Northwest Inc (NASDAQ:FFNW) is currently trading at a trailing P/E of 11.5x, which is lower than the industry average of 17.5x. 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Demystifying 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.
P/E Calculation for FFNW
Price-Earnings Ratio = Price per share ÷ Earnings per share
FFNW Price-Earnings Ratio = $15.94 ÷ $1.386 = 11.5x
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 FFNW, 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. At 11.5, FFNW’s P/E is lower than its industry peers (17.5). This implies that investors are undervaluing each dollar of FFNW’s earnings. This multiple is a median of profitable companies of 25 Banks companies in US including Great Basin Financial, CIB Marine Bancshares and Citizens Commerce Bancshares. One could put it like this: the market is pricing FFNW as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to FFNW. 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 FFNW, 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 FFNW to are fairly valued by the market. If this is violated, FFNW’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of FFNW to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for FFNW’s future growth? Take a look at our free research report of analyst consensus for FFNW’s outlook.
- Past Track Record: Has FFNW 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 FFNW’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.