I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
E*TRADE Financial Corporation (NASDAQ:ETFC) trades with a trailing P/E of 21.4x, which is higher than the industry average of 15.9x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 = $59.81
Earnings per share = $2.793
∴ Price-Earnings Ratio = $59.81 ÷ $2.793 = 21.4x
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. 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 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.
Since ETFC’s P/E of 21.4x is higher than its industry peers (15.9x), it means that investors are paying more than they should for each dollar of ETFC’s earnings. This multiple is a median of profitable companies of 25 Capital Markets companies in US including Modern Technology, Neon Capital and Oracle Healthcare Acquisition. Therefore, according to this analysis, ETFC is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your ETFC shares, it is important to note that this conclusion is based on two key assumptions. 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 inadvertently compared riskier firms with ETFC, then investors would naturally value ETFC at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with ETFC, investors would also value ETFC at a higher price since it is a higher growth investment. Both scenarios would explain why ETFC has a higher P/E ratio than its peers. 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:
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 ETFC. 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 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.
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.