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 Enterprise Bancorp, Inc.'s (NASDAQ:EBTC) P/E ratio could help you assess the value on offer. Enterprise Bancorp has a price to earnings ratio of 11.91, based on the last twelve months. That means that at current prices, buyers pay $11.91 for every $1 in trailing yearly profits.
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 Enterprise Bancorp:
P/E of 11.91 = USD32.36 ÷ USD2.72 (Based on the year to September 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. 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 Enterprise Bancorp's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below Enterprise Bancorp has a P/E ratio that is fairly close for the average for the banks industry, which is 12.8.
That indicates that the market expects Enterprise Bancorp will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. Checking factors such as director buying and selling. could help you form your own view on if that will happen.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Enterprise Bancorp increased earnings per share by a whopping 26% last year. And its annual EPS growth rate over 5 years is 14%. With that performance, I would expect it to have an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Enterprise Bancorp's Debt Impact Its P/E Ratio?
Enterprise Bancorp has net cash of US$56m. 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 Enterprise Bancorp's P/E Ratio
Enterprise Bancorp trades on a P/E ratio of 11.9, which is below the US market average of 19.0. Not only should the net cash position reduce risk, but the recent growth has been impressive. The below average P/E ratio suggests that market participants don't believe the strong growth will continue.
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. Although we don't have analyst forecasts you might want to assess this data-rich visualization of earnings, revenue and cash flow.
But note: Enterprise Bancorp may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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.