This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Southern Missouri Bancorp Inc (NASDAQ:SMBC) is currently trading at a trailing P/E of 13x, which is lower than the industry average of 17.9x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about 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 SMBC
Price-Earnings Ratio = Price per share ÷ Earnings per share
SMBC Price-Earnings Ratio = $33.6 ÷ $2.588 = 13x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SMBC, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. SMBC’s P/E of 13 is lower than its industry peers (17.9), which implies that each dollar of SMBC’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Mortgage companies in US including Security National Financial, PennyMac Financial Services and Bank7. You can think of it like this: the market is suggesting that SMBC is a weaker business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to SMBC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with SMBC, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing SMBC to are fairly valued by the market. If this is violated, SMBC’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 SMBC 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SMBC’s future growth? Take a look at our free research report of analyst consensus for SMBC’s outlook.
- Past Track Record: Has SMBC 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 SMBC’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.