I am writing today to help inform people who are new to 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.
HomeTrust Bancshares Inc (NASDAQ:HTBI) is trading with a trailing P/E of 65x, which is higher than the industry average of 16.3x. While this makes HTBI appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down 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. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for HTBI
Price-Earnings Ratio = Price per share ÷ Earnings per share
HTBI Price-Earnings Ratio = $29.7 ÷ $0.457 = 65x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as HTBI, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. HTBI’s P/E of 65x is higher than its industry peers (16.3x), which implies that each dollar of HTBI’s earnings is being overvalued by investors. 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, HTBI is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your HTBI shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to HTBI, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with HTBI, 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 HTBI to are fairly valued by the market. If this does not hold true, HTBI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 rebalance your portfolio and reduce your holdings in HTBI. 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 HTBI’s future growth? Take a look at our free research report of analyst consensus for HTBI’s outlook.
- Past Track Record: Has HTBI 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 HTBI’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.