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Is Heritage Financial Corporation's (NASDAQ:HFWA) High P/E Ratio A Problem For Investors?

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Simply Wall St
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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Heritage Financial Corporation's (NASDAQ:HFWA) P/E ratio to inform your assessment of the investment opportunity. What is Heritage Financial's P/E ratio? Well, based on the last twelve months it is 15.16. That means that at current prices, buyers pay $15.16 for every $1 in trailing yearly profits.

Check out our latest analysis for Heritage Financial

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 Heritage Financial:

P/E of 15.16 = $27.55 ÷ $1.82 (Based on the year to September 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Does Heritage Financial's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Heritage Financial has a higher P/E than the average (12.9) P/E for companies in the banks industry.

NasdaqGS:HFWA Price Estimation Relative to Market, December 16th 2019
NasdaqGS:HFWA Price Estimation Relative to Market, December 16th 2019

That means that the market expects Heritage Financial will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.

Heritage Financial increased earnings per share by a whopping 32% last year. And earnings per share have improved by 23% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

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. 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).

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

So What Does Heritage Financial's Balance Sheet Tell Us?

With net cash of US$174m, Heritage Financial has a very strong balance sheet, which may be important for its business. Having said that, at 17% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Heritage Financial's P/E Ratio

Heritage Financial trades on a P/E ratio of 15.2, which is below the US market average of 18.6. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic.

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 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.