Sound Financial Bancorp Inc (NASDAQ:SFBC) is trading with a trailing P/E of 15.3x, which is lower than the industry average of 18.6x. While this makes SFBC appear like a great stock to buy, 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. View our latest analysis for Sound Financial Bancorp
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. 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 SFBC
Price-Earnings Ratio = Price per share ÷ Earnings per share
SFBC Price-Earnings Ratio = 33.75 ÷ 2.2 = 15.3x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 SFBC, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. SFBC’s P/E of 15.3x is lower than its industry peers (18.6x), which implies that each dollar of SFBC’s earnings is being undervalued by investors. As such, our analysis shows that SFBC represents an under-priced stock.
A few caveats
Before you jump to the conclusion that SFBC is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to SFBC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with SFBC, 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 SFBC to are fairly valued by the market. If this does not hold true, SFBC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? 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 SFBC 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.
Are you a potential investor? If SFBC has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
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 Sound Financial Bancorp 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.