Village Bank and Trust Financial Corp (NASDAQ:VBFC) is currently trading at a trailing P/E of 52.1x, which is higher than the industry average of 17.8x. While VBFC 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. 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 VBFC

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for VBFC

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

VBFC Price-Earnings Ratio = 31.97 ÷ 0.613 = 52.1x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to VBFC, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since VBFC’s P/E of 52.1x is higher than its industry peers (17.8x), it means that investors are paying more than they should for each dollar of VBFC’s earnings. Therefore, according to this analysis, VBFC is an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your VBFC shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to VBFC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with VBFC, 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 VBFC to are fairly valued by the market. If this does not hold, there is a possibility that VBFC’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? 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 VBFC. 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.