This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
First Northwest Bancorp (NASDAQ:FNWB) trades with a trailing P/E of 56.4, which is higher than the industry average of 17.9. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E 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 FNWB
Price-Earnings Ratio = Price per share ÷ Earnings per share
FNWB Price-Earnings Ratio = $16.69 ÷ $0.296 = 56.4x
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 FNWB, 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 56.4, FNWB’s P/E is higher than its industry peers (17.9). This implies that investors are overvaluing each dollar of FNWB’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. You could also say that the market is suggesting that FNWB is a stronger business than the average comparable company.
A few caveats
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to FNWB. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where First Northwest Bancorp is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with FNWB are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
Since you may have already conducted your due diligence on FNWB, 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. 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 FNWB’s future growth? Take a look at our free research report of analyst consensus for FNWB’s outlook.
- Past Track Record: Has FNWB 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 FNWB’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 email@example.com.