The Charles Schwab Corporation (NYSE:SCHW) is currently trading at a trailing P/E of 34.4x, which is higher than the industry average of 16.2x. While SCHW 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Charles Schwab

Breaking down 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.

P/E Calculation for SCHW

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

SCHW Price-Earnings Ratio = $55.97 ÷ $1.628 = 34.4x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SCHW, 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. At 34.4x, SCHW’s P/E is higher than its industry peers (16.2x). This implies that investors are overvaluing each dollar of SCHW’s earnings. Therefore, according to this analysis, SCHW is an over-priced stock.

Assumptions to be aware of

Before you jump to the conclusion that SCHW 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 SCHW, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with SCHW, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing SCHW to are fairly valued by the market. If this does not hold, there is a possibility that SCHW’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass 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.