The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at HMN Financial, Inc.'s (NASDAQ:HMNF) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, HMN Financial has a P/E ratio of 11.66. That corresponds to an earnings yield of approximately 8.6%.
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How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for HMN Financial:
P/E of 11.66 = $22 ÷ $1.89 (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
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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
HMN Financial's 72% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Even better, EPS is up 22% per year over three years. So you might say it really deserves to have an above-average P/E ratio. On the other hand, the longer term performance is poor, with EPS down 22% per year over 5 years.
How Does HMN Financial's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see HMN Financial has a lower P/E than the average (14.2) in the mortgage industry classification.
This suggests that market participants think HMN Financial will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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. Thus, the metric does not reflect cash or debt held by the company. 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 HMN Financial's Balance Sheet Tell Us?
HMN Financial has net cash of US$15m. This is fairly high at 15% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Bottom Line On HMN Financial's P/E Ratio
HMN Financial's P/E is 11.7 which is below average (17.7) in the US market. Not only should the net cash position reduce risk, but the recent growth has been impressive. One might conclude that the market is a bit pessimistic, given the low P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. 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.' We don't have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than HMN Financial. 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.