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.
First Community Bancshares Inc (NASDAQ:FCBC) is currently trading at a trailing P/E of 21.2x, which is higher than the industry average of 16.2x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the Price-Earnings 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 FCBC
Price-Earnings Ratio = Price per share ÷ Earnings per share
FCBC Price-Earnings Ratio = $33.61 ÷ $1.585 = 21.2x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FCBC, 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. FCBC’s P/E of 21.2x is higher than its industry peers (16.2x), which implies that each dollar of FCBC’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. As such, our analysis shows that FCBC represents an over-priced stock.
A few caveats
However, before you rush out to sell your FCBC shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to FCBC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with FCBC, 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 FCBC to are fairly valued by the market. If this does not hold true, FCBC’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 FCBC. 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 FCBC’s future growth? Take a look at our free research report of analyst consensus for FCBC’s outlook.
- Past Track Record: Has FCBC 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 FCBC’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.