This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
The Bank of Princeton (NASDAQ:BPRN) is currently trading at a trailing P/E of 17.7x, which is higher than the industry average of 16.3x. 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. In this article, 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 BPRN
Price per share = $33.38
Earnings per share = $1.885
∴ Price-Earnings Ratio = $33.38 ÷ $1.885 = 17.7x
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 BPRN, such as capital structure and profitability. 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.
BPRN’s P/E of 17.7x is higher than its industry peers (16.3x), which implies that each dollar of BPRN’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, CIB Marine Bancshares and Citizens Commerce Bancshares. As such, our analysis shows that BPRN represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your BPRN shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to BPRN. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with BPRN, then BPRN’s P/E would naturally be higher since investors would reward BPRN’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with BPRN, BPRN’s P/E would again be higher since investors would reward BPRN’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing BPRN to are fairly valued by the market. If this assumption is violated, BPRN’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 BPRN. 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 BPRN’s future growth? Take a look at our free research report of analyst consensus for BPRN’s outlook.
- Past Track Record: Has BPRN 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 BPRN’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.