This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Pacific Mercantile Bancorp (NASDAQ:PMBC) is currently trading at a trailing P/E of 9.2x, which is lower than the industry average of 16.3x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for PMBC
Price per share = $9.95
Earnings per share = $1.086
∴ Price-Earnings Ratio = $9.95 ÷ $1.086 = 9.2x
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 PMBC, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since PMBC’s P/E of 9.2x is lower than its industry peers (16.3x), it means that investors are paying less than they should for each dollar of PMBC’s earnings. 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. Therefore, according to this analysis, PMBC is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that PMBC represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to PMBC. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with PMBC, then PMBC’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with PMBC, PMBC’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing PMBC to are fairly valued by the market. If this does not hold, there is a possibility that PMBC’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on PMBC, the undervaluation of the stock may mean it is a good time to top up on 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for PMBC’s future growth? Take a look at our free research report of analyst consensus for PMBC’s outlook.
- Past Track Record: Has PMBC 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 PMBC’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.