This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Southern National Bancorp of Virginia Inc (NASDAQ:SONA) is currently trading at a trailing P/E of 18.7, which is higher than the industry average of 17.2. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. In this article, 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 SONA
Price-Earnings Ratio = Price per share ÷ Earnings per share
SONA Price-Earnings Ratio = $15.86 ÷ $0.847 = 18.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SONA, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since SONA’s P/E of 18.7 is higher than its industry peers (17.2), it means that investors are paying more for each dollar of SONA’s earnings. This multiple is a median of profitable companies of 25 Banks companies in US including CIB Marine Bancshares, Citizens Commerce Bancshares and Limestone Bancorp. You could think of it like this: the market is pricing SONA as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to SONA. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Southern National Bancorp of Virginia Inc 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. We should also be aware that the stocks we are comparing to SONA may not be fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on SONA, 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 SONA’s future growth? Take a look at our free research report of analyst consensus for SONA’s outlook.
Past Track Record: Has SONA 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 SONA’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.