E*TRADE Financial Corporation (NASDAQ:ETFC) is currently trading at a trailing P/E of 25.2x, which is higher than the industry average of 16.4x. While ETFC 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for E*TRADE Financial
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 ETFC
Price per share = $64.39
Earnings per share = $2.552
∴ Price-Earnings Ratio = $64.39 ÷ $2.552 = 25.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ETFC, such as size and country of operation. 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.
ETFC’s P/E of 25.2x is higher than its industry peers (16.4x), which implies that each dollar of ETFC’s earnings is being overvalued by investors. As such, our analysis shows that ETFC represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your ETFC shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to ETFC. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with ETFC, then ETFC’s P/E would naturally be higher since investors would reward ETFC’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with ETFC, ETFC’s P/E would again be higher since investors would reward ETFC’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing ETFC to are fairly valued by the market. If this assumption does not hold true, ETFC’s higher P/E ratio may be 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 ETFC. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for ETFC’s future growth? Take a look at our free research report of analyst consensus for ETFC’s outlook.
- Past Track Record: Has ETFC 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 ETFC’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.