Norwood Financial Corp (NASDAQ:NWFL) is trading with a trailing P/E of 22.6x, which is higher than the industry average of 18.6x. 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. See our latest analysis for NWFL
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.
P/E Calculation for NWFL
Price-Earnings Ratio = Price per share ÷ Earnings per share
NWFL Price-Earnings Ratio = 29.7 ÷ 1.312 = 22.6x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as NWFL, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. NWFL’s P/E of 22.6x is higher than its industry peers (18.6x), which implies that each dollar of NWFL’s earnings is being overpriced by investors. As such, our analysis shows that NWFL represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your NWFL shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to NWFL, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with NWFL, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing NWFL to are fairly valued by the market. If this does not hold true, NWFL’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? 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 NWFL. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If NWFL has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.