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 Northrim BanCorp, Inc.’s (NASDAQ:NRIM) P/E ratio could help you assess the value on offer. Northrim BanCorp has a price to earnings ratio of 15.62, based on the last twelve months. That corresponds to an earnings yield of approximately 6.4%.
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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 Northrim BanCorp:
P/E of 15.62 = $34.94 ÷ $2.24 (Based on the year to September 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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
When earnings fall, the ‘E’ decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
Northrim BanCorp saw earnings per share decrease by 6.7% last year. And over the longer term (3 years) earnings per share have decreased 9.4% annually. So we might expect a relatively low P/E.
How Does Northrim BanCorp’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (14.5) for companies in the banks industry is lower than Northrim BanCorp’s P/E.
Its relatively high P/E ratio indicates that Northrim BanCorp shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
Remember: P/E Ratios Don’t Consider The Balance Sheet
The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Northrim BanCorp’s Balance Sheet
Since Northrim BanCorp holds net cash of US$20m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Northrim BanCorp’s P/E Ratio
Northrim BanCorp has a P/E of 15.6. That’s below the average in the US market, which is 17.1. The recent drop in earnings per share would make investors cautious, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there’s real potential that the low P/E could eventually indicate undervaluation.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course you might be able to find a better stock than Northrim BanCorp. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 firstname.lastname@example.org.