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TowneBank (NASDAQ:TOWN) is currently trading at a trailing P/E of 21.2x, which is higher than the industry average of 17.3x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for TowneBank
Demystifying 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 TOWN
Price-Earnings Ratio = Price per share ÷ Earnings per share
TOWN Price-Earnings Ratio = $29.95 ÷ $1.41 = 21.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to TOWN, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since TOWN’s P/E of 21.2x is higher than its industry peers (17.3x), it means that investors are paying more than they should for each dollar of TOWN’s earnings. Therefore, according to this analysis, TOWN is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your TOWN 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 TOWN, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with TOWN, 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 TOWN to are fairly valued by the market. If this does not hold, there is a possibility that TOWN’s P/E is lower because our peer group is overvalued 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 TOWN. 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: