I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Sterling Bancorp (NYSE:STL) trades with a trailing P/E of 17.5, which is higher than the industry average of 16.3. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 STL
Price-Earnings Ratio = Price per share ÷ Earnings per share
STL Price-Earnings Ratio = $18.96 ÷ $1.081 = 17.5x
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 STL, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. STL’s P/E of 17.5 is higher than its industry peers (16.3), which implies that each dollar of STL’s earnings is being overvalued by investors. 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 also say that the market is suggesting that STL is a stronger business than the average comparable company.
Assumptions to be aware of
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to STL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Sterling Bancorp is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to STL may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
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 STL. 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 STL’s future growth? Take a look at our free research report of analyst consensus for STL’s outlook.
- Past Track Record: Has STL 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 STL’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.