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 National Bankshares, Inc.’s (NASDAQ:NKSH) P/E ratio could help you assess the value on offer. National Bankshares has a P/E ratio of 17.03, based on the last twelve months. In other words, at today’s prices, investors are paying $17.03 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for National Bankshares:
P/E of 17.03 = $35.91 ÷ $2.11 (Based on the year to September 2018.)
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.
How Growth Rates Impact P/E Ratios
When earnings fall, the ‘E’ decreases, over time. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
National Bankshares maintained roughly steady earnings over the last twelve months. And it has shrunk its earnings per share by 5.5% per year over the last five years. So we might expect a relatively low P/E.
How Does National Bankshares’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below, National Bankshares has a higher P/E than the average company (14) in the banks industry.
National Bankshares’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.
Remember: P/E Ratios Don’t Consider The Balance Sheet
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.
How Does National Bankshares’s Debt Impact Its P/E Ratio?
Since National Bankshares holds net cash of US$4.9m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On National Bankshares’s P/E Ratio
National Bankshares trades on a P/E ratio of 17, which is above the US market average of 15.8. Earnings improved over the last year. And the net cash position provides the company with multiple options. The high P/E suggests the market thinks further growth will come.
When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ 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.