PB Bancorp Inc (NASDAQ:PBBI) trades with a trailing P/E of 26.4x, which is higher than the industry average of 22.1x. While this makes PBBI appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. 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 PB Bancorp

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief 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.

P/E Calculation for PBBI

Price-Earnings Ratio = Price per share ÷ Earnings per share

PBBI Price-Earnings Ratio = $10.63 ÷ $0.403 = 26.4x

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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to PBBI, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. PBBI’s P/E of 26.4x is higher than its industry peers (22.1x), which implies that each dollar of PBBI’s earnings is being overvalued by investors. As such, our analysis shows that PBBI represents an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that PBBI should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to PBBI, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with PBBI, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing PBBI to are fairly valued by the market. If this does not hold, there is a possibility that PBBI’s P/E is lower because our peer group is overvalued 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 PBBI. 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: