HopFed Bancorp Inc (NASDAQ:HFBC) is trading with a trailing P/E of 19.1x, which is lower than the industry average of 22.6x. While this makes HFBC appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for HopFed Bancorp
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 HFBC
Price-Earnings Ratio = Price per share ÷ Earnings per share
HFBC Price-Earnings Ratio = $14.1 ÷ $0.737 = 19.1x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to HFBC, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since HFBC’s P/E of 19.1x is lower than its industry peers (22.6x), it means that investors are paying less than they should for each dollar of HFBC’s earnings. As such, our analysis shows that HFBC represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy HFBC immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to HFBC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with HFBC, 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 HFBC to are fairly valued by the market. If this does not hold true, HFBC’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 add more of HFBC to your portfolio. 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 you are considering investing in HFBC, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.