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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how HomeStreet, Inc.'s (NASDAQ:HMST) P/E ratio could help you assess the value on offer. What is HomeStreet's P/E ratio? Well, based on the last twelve months it is 18.78. In other words, at today's prices, investors are paying $18.78 for every $1 in prior year profit.
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 HomeStreet:
P/E of 18.78 = $30.15 ÷ $1.61 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
HomeStreet shrunk earnings per share by 30% over the last year. But EPS is up 9.0% over the last 5 years. And over the longer term (3 years) earnings per share have decreased 1.3% annually. This could justify a low P/E.
Does HomeStreet Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, HomeStreet has a higher P/E than the average company (14.4) in the mortgage industry.
That means that the market expects HomeStreet will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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.
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.
How Does HomeStreet's Debt Impact Its P/E Ratio?
HomeStreet has net debt worth 81% of its market capitalization. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Bottom Line On HomeStreet's P/E Ratio
HomeStreet's P/E is 18.8 which is about average (18.2) in the US market. With relatively high debt, and no earnings per share growth over twelve months, the P/E suggests that many have an expectation that company will find some growth.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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 email@example.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.