Price-to-earnings (P/E) ratios are popular valuation metrics among stock market investors. The ratio is a simple measure of the company's stock price relative to its earnings per share (EPS). High P/E ratios suggest that a stock is trading at a high price relative to earnings and might be overvalued. However, looking at P/E ratios alone isn't enough. One must also consider the company's earnings growth rate, its historical P/E ratio, and the ratios of the overall sector. That's certainly the case with banking stocks today.

Understanding P/E Ratios

The price-to-earnings (P/E) ratio is one of the most widely used equity evaluation measures by investors and analysts. It is simple to calculate because the ratio is computed by dividing the current stock price by EPS. The result provides investors an assessment of a company's profits in relation to the price that investors have to pay for the company's stock. It is thus not merely an evaluation of the company, but an evaluation of the company's stock at current price levels as well.

Key Takeaways

  • A P/E ratio is a popular metric that is easy to compute because it is merely the company's stock price divided by the annual earnings per share.
  • P/E ratios are often used to determine if stocks are over or undervalued.
  • Looking at P/E ratios alone isn't enough because other factors, such as the company's growth rates and sector affiliation, come into play as well.
  • In the banking sector, many of the big names trade at lower multiples compared to regional banks, which have greater potential for rapid growth.

As with all equity valuation metrics, the P/E ratio as a standalone number is of limited usefulness for analysis. For example, a company with a high earnings growth rate should typically command a higher P/E ratio because of the EPS component of the equation is increasing faster than the EPS of a slow-growth company. In addition, a P/E ratio might seem high, but this might be due to one or two quarters of weak numbers during a longer period of consistent earnings growth rates.

P/E Ratios and the Banking Sector

A company's P/E ratio is also important in terms of how it compares with similar firms in the same industry. For example, as of August 2018, Wells Fargo (WFC), one of the "big four" banks in the United States, was trading with a P/E ratio of 15, while its competitor, Citigroup (C), had a P/E ratio of 11. Is that high or low?

Well, the banking sector as a whole had a P/E ratio of approximately 25.16 and compares with an overall market average P/E ratio of 71.28. However, this is a simple arithmetic average of P/E ratios is skewed by the figures for a very small number of firms with P/E ratios over 100 or 200. Still, the ratios of both Citi and Wells Fargo are well below the average for the industry and for the market as a whole.

The best-performing regional banks, because of the larger potential for rapid growth, tend to have P/E ratios noticeably higher than those for the major banks, which are large companies with relatively steady growth in revenues and earnings. The P/E of the major banks is 17.09, compared to 33.24 for the smaller regional banks. A mean or median average would show the banking industry's average P/E ratio much closer to typical market performance.

In sum, higher P/E ratios are typically considered to indicate higher growth and increased revenue potential, or at least that investors are anticipating higher growth, since they are willing to pay a greater multiple of current earnings per share to obtain the company's stock. However, if the company has a high P/E ratio relative to the overall market, and also high valuations relative to its peers in the sector, while earnings growth shows signs of deceleration, watch out! The stock might be overvalued.