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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 First Defiance Financial Corp.’s (NASDAQ:FDEF) P/E ratio could help you assess the value on offer. Based on the last twelve months, First Defiance Financial’s P/E ratio is 12.83. That corresponds to an earnings yield of approximately 7.8%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for First Defiance Financial:
P/E of 12.83 = $29.15 ÷ $2.27 (Based on the trailing twelve months to December 2018.)
Is A High P/E 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. 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.
First Defiance Financial increased earnings per share by a whopping 40% last year. And it has bolstered its earnings per share by 13% 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 Defiance Financial’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that First Defiance Financial has a lower P/E than the average (15.6) P/E for companies in the mortgage industry.
Its relatively low P/E ratio indicates that First Defiance Financial shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with First Defiance Financial, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or 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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Is Debt Impacting First Defiance Financial’s P/E?
First Defiance Financial has net debt worth just 4.8% of its market capitalization. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Verdict On First Defiance Financial’s P/E Ratio
First Defiance Financial’s P/E is 12.8 which is below average (16.8) in the US market. The company does have a little debt, and EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold they key to an excellent investment decision.
But note: First Defiance Financial may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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 firstname.lastname@example.org.