The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how First Financial Northwest, Inc.’s (NASDAQ:FFNW) P/E ratio could help you assess the value on offer. First Financial Northwest has a price to earnings ratio of 14.91, based on the last twelve months. That corresponds to an earnings yield of approximately 6.7%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for First Financial Northwest:
P/E of 14.91 = $14.89 ÷ $1.00 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does First Financial Northwest Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that First Financial Northwest has a higher P/E than the average (12.7) P/E for companies in the banks industry.
First Financial Northwest’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
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. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
First Financial Northwest saw earnings per share decrease by 28% last year. But it has grown its earnings per share by 6.3% per year over the last five years.
Remember: P/E Ratios Don’t Consider The Balance Sheet
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
First Financial Northwest’s Balance Sheet
First Financial Northwest’s net debt equates to 50% of its market capitalization. While that’s enough to warrant consideration, it doesn’t really concern us.
The Bottom Line On First Financial Northwest’s P/E Ratio
First Financial Northwest trades on a P/E ratio of 14.9, which is below the US market average of 18.2. Since it only carries a modest debt load, it’s likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than First Financial Northwest. So you may wish to see this free collection of other companies that have grown earnings strongly.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.