This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Provident Bancorp Inc (NASDAQ:PVBC) trades with a trailing P/E of 29x, which is higher than the industry average of 18.5x. While PVBC might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the Price-Earnings 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for PVBC
Price per share = $28.1
Earnings per share = $0.968
∴ Price-Earnings Ratio = $28.1 ÷ $0.968 = 29x
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 PVBC, 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 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.
PVBC’s P/E of 29x is higher than its industry peers (18.5x), which implies that each dollar of PVBC’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Mortgage companies in US including Solutions Group, Security National Financial and PennyMac Financial Services. Therefore, according to this analysis, PVBC is an over-priced stock.
A few caveats
Before you jump to the conclusion that PVBC should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to PVBC. 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 PVBC, then PVBC’s P/E would naturally be higher since investors would reward PVBC’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with PVBC, PVBC’s P/E would again be higher since investors would reward PVBC’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing PVBC to are fairly valued by the market. If this does not hold, there is a possibility that PVBC’s P/E is higher because firms in our peer group are being undervalued 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 PVBC. 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 PVBC’s future growth? Take a look at our free research report of analyst consensus for PVBC’s outlook.
- Financial Health: Are PVBC’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- 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.