This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Mercantile Bank Corporation's (NASDAQ:MBWM) P/E ratio could help you assess the value on offer. Mercantile Bank has a P/E ratio of 12.28, based on the last twelve months. That corresponds to an earnings yield of approximately 8.1%.
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 Mercantile Bank:
P/E of 12.28 = $33.63 ÷ $2.74 (Based on the year to June 2019.)
Is A High Price-to-Earnings 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 Does Mercantile Bank'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 (12.6) for companies in the banks industry is roughly the same as Mercantile Bank's P/E.
Mercantile Bank's P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Mercantile Bank increased earnings per share by an impressive 24% over the last twelve months. And earnings per share have improved by 13% annually, over the last five years. This could arguably justify a relatively high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
So What Does Mercantile Bank's Balance Sheet Tell Us?
Mercantile Bank's net debt is 70% of its market cap. 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 Mercantile Bank's P/E Ratio
Mercantile Bank has a P/E of 12.3. That's below the average in the US market, which is 17.9. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. 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 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 Mercantile Bank. 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 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.