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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at First Northwest Bancorp’s (NASDAQ:FNWB) P/E ratio and reflect on what it tells us about the company’s share price. First Northwest Bancorp has a P/E ratio of 23.33, based on the last twelve months. That corresponds to an earnings yield of approximately 4.3%.
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 Northwest Bancorp:
P/E of 23.33 = $16.1 ÷ $0.69 (Based on the trailing twelve months to December 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. 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
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 Northwest Bancorp grew EPS by a whopping 121% in the last year. And it has bolstered its earnings per share by 53% per year over the last five years. With that performance, I would expect it to have an above average P/E ratio.
How Does First Northwest 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 (13.5) for companies in the banks industry is lower than First Northwest Bancorp’s P/E.
Its relatively high P/E ratio indicates that First Northwest Bancorp shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn’t guaranteed. So further research is always essential. I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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).
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 Northwest Bancorp’s Balance Sheet
First Northwest Bancorp’s net debt is 66% of its 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 Northwest Bancorp’s P/E Ratio
First Northwest Bancorp trades on a P/E ratio of 23.3, which is above the US market average of 17.4. It’s good to see the recent earnings growth, although we note the company uses debt already. It seems the market believes growth will continue, judging by the P/E ratio.
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.’ Although we don’t have analyst forecasts, you might want to assess this data-rich visualization of earnings, revenue and cash flow.
You might be able to find a better buy than First Northwest Bancorp. 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 firstname.lastname@example.org. 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.