This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Arrow Financial Corporation’s (NASDAQ:AROW) P/E ratio could help you assess the value on offer. Arrow Financial has a P/E ratio of 12.62, based on the last twelve months. That is equivalent to an earnings yield of about 7.9%.
View our latest analysis for Arrow Financial
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Arrow Financial:
P/E of 12.62 = $31.25 ÷ $2.48 (Based on the year to September 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Notably, Arrow Financial grew EPS by a whopping 27% in the last year. And its annual EPS growth rate over 5 years is 8.2%. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Arrow Financial’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (13.9) for companies in the banks industry is higher than Arrow Financial’s P/E.
Its relatively low P/E ratio indicates that Arrow Financial shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Arrow Financial, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Arrow Financial’s Debt Impact Its P/E Ratio?
Arrow Financial’s net debt is 36% of its market cap. This is a reasonably significant level of debt — all else being equal you’d expect a much lower P/E than if it had net cash.
The Bottom Line On Arrow Financial’s P/E Ratio
Arrow Financial trades on a P/E ratio of 12.6, which is below the US market average of 15.6. The company does have a little debt, and EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
To help readers see past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.