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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll show how you can use First Merchants Corporation’s (NASDAQ:FRME) P/E ratio to inform your assessment of the investment opportunity. First Merchants has a P/E ratio of 11.81, based on the last twelve months. That corresponds to an earnings yield of approximately 8.5%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for First Merchants:
P/E of 11.81 = $38.15 ÷ $3.23 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the ‘E’ will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Notably, First Merchants grew EPS by a whopping 52% in the last year. And its annual EPS growth rate over 5 years is 14%. With that performance, I would expect it to have an above average P/E ratio.
How Does First Merchants’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (13.3) for companies in the banks industry is higher than First Merchants’s P/E.
First Merchants’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Is Debt Impacting First Merchants’s P/E?
Net debt totals 26% of First Merchants’s 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 Verdict On First Merchants’s P/E Ratio
First Merchants has a P/E of 11.8. That’s below the average in the US market, which is 16.8. The company hasn’t stretched its balance sheet, and earnings growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified. Because analysts are predicting more growth in the future, one might have expected to see a higher P/E ratio. You can taker closer look at the fundamentals, here.
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 visual report on analyst forecasts could hold they key to an excellent investment decision.
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 email@example.com.