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Is TowneBank’s (NASDAQ:TOWN) High P/E Ratio A Problem For Investors?

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Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll look at TowneBank’s (NASDAQ:TOWN) P/E ratio and reflect on what it tells us about the company’s share price. TowneBank has a P/E ratio of 13.52, based on the last twelve months. That is equivalent to an earnings yield of about 7.4%.

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for TowneBank:

P/E of 13.52 = \$26.41 ÷ \$1.95 (Based on the trailing twelve months to March 2019.)

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. 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

Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Notably, TowneBank grew EPS by a whopping 38% in the last year. And earnings per share have improved by 11% annually, over the last five years. So we’d generally expect it to have a relatively high P/E ratio.

Does TowneBank Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (13) for companies in the banks industry is roughly the same as TowneBank’s P/E.

Its P/E ratio suggests that TowneBank shareholders think that in the future it will perform about the same as other companies in its industry classification. The company could surprise by performing better than average, in the future. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn’t take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

TowneBank’s Balance Sheet

TowneBank has net debt worth just 6.9% of its market capitalization. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Verdict On TowneBank’s P/E Ratio

TowneBank trades on a P/E ratio of 13.5, which is below the US market average of 18. The company does have a little debt, and EPS growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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.

You might be able to find a better buy than TowneBank. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.