The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Norwegian Finans Holding ASA (OB:NOFI) is currently trading at a trailing P/E of 11.2x, which is higher than the industry average of 9.1x. While this makes NOFI appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 NOFI
Price per share = NOK100.8
Earnings per share = NOK8.988
∴ Price-Earnings Ratio = NOK100.8 ÷ NOK8.988 = 11.2x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to NOFI, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
NOFI’s P/E of 11.2x is higher than its industry peers (9.1x), which implies that each dollar of NOFI’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Banks companies in NO including Sparebank 1 Nordvest, Surnadalrebank and LillestrømBanken. As such, our analysis shows that NOFI represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that NOFI should be banished from your portfolio, 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 NOFI. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with NOFI, then NOFI’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with NOFI. In this case, NOFI’s P/E would be higher since investors would also reward NOFI’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing NOFI to are fairly valued by the market. If this assumption is violated, NOFI’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to NOFI. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 NOFI’s future growth? Take a look at our free research report of analyst consensus for NOFI’s outlook.
- Past Track Record: Has NOFI 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 NOFI’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.