I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Sterling Bancorp Inc (Southfield MI) (NASDAQ:SBT) is currently trading at a trailing P/E of 12.8x, which is lower than the industry average of 19.6x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the Price-Earnings 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 SBT
Price-Earnings Ratio = Price per share ÷ Earnings per share
SBT Price-Earnings Ratio = $12.89 ÷ $1.006 = 12.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SBT, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since SBT’s P/E of 12.8 is lower than its industry peers (19.6), it means that investors are paying less for each dollar of SBT’s earnings. This multiple is a median of profitable companies of 25 Mortgage companies in US including Solutions Group, Security National Financial and PennyMac Financial Services. You can think of it like this: the market is suggesting that SBT is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to SBT. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with SBT, 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 SBT to are fairly valued by the market. If this does not hold, there is a possibility that SBT’s P/E is lower because our peer group is 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 add more of SBT 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 SBT’s future growth? Take a look at our free research report of analyst consensus for SBT’s outlook.
- Financial Health: Are SBT’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- 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.