Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Coastal Financial Corporation's (NASDAQ:CCB) P/E ratio could help you assess the value on offer. Coastal Financial has a price to earnings ratio of 16.46, based on the last twelve months. In other words, at today's prices, investors are paying $16.46 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 Coastal Financial:
P/E of 16.46 = $17.50 ÷ $1.06 (Based on the trailing twelve months to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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 Coastal 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. You can see in the image below that the average P/E (12.6) for companies in the banks industry is lower than Coastal Financial's P/E.
Coastal Financial's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. 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.
It's nice to see that Coastal Financial grew EPS by a stonking 49% in the last year. And earnings per share have improved by 33% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.
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. 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 investing in growth. That means taking on debt (or spending its cash).
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.
So What Does Coastal Financial's Balance Sheet Tell Us?
With net cash of US$95m, Coastal Financial has a very strong balance sheet, which may be important for its business. Having said that, at 46% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Coastal Financial's P/E Ratio
Coastal Financial's P/E is 16.5 which is below average (18.2) in the US market. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The below average P/E ratio suggests that market participants don't believe the strong growth will continue. Given analysts are expecting further growth, one I would have expected a higher P/E ratio. So this stock may well be worth further research.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the 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.
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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.