Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
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 Canadian Western Bank's (TSE:CWB) P/E ratio could help you assess the value on offer. Based on the last twelve months, Canadian Western Bank's P/E ratio is 9.75. That is equivalent to an earnings yield of about 10%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Canadian Western Bank:
P/E of 9.75 = CA$27.88 ÷ CA$2.86 (Based on the trailing twelve months to January 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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 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. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Canadian Western Bank increased earnings per share by an impressive 12% over the last twelve months. And earnings per share have improved by 3.5% annually, over the last five years. So one might expect an above average P/E ratio.
Does Canadian Western Bank Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (10.3) for companies in the banks industry is roughly the same as Canadian Western Bank's P/E.
Its P/E ratio suggests that Canadian Western Bank shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. I inform my view byby checking management tenure and remuneration, among other things.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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 Canadian Western Bank's Balance Sheet Tell Us?
Canadian Western Bank has net debt worth 76% 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 Verdict On Canadian Western Bank's P/E Ratio
Canadian Western Bank's P/E is 9.7 which is below average (14.7) in the CA market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. 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 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.
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.