This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Canadian Western Bank's (TSE:CWB) P/E ratio and reflect on what it tells us about the company's share price. What is Canadian Western Bank's P/E ratio? Well, based on the last twelve months it is 10.44. In other words, at today's prices, investors are paying CA$10.44 for every CA$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Canadian Western Bank:
P/E of 10.44 = CA$31.84 ÷ CA$3.05 (Based on the trailing twelve months to October 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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'.
Does Canadian Western Bank Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Canadian Western Bank has a P/E ratio that is roughly in line with the banks industry average (11.2).
That indicates that the market expects Canadian Western Bank will perform roughly in line with other companies in its industry. So if Canadian Western Bank actually outperforms its peers going forward, that should be a positive for the share price. I would further inform my view by checking insider buying and selling., among other things.
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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Canadian Western Bank increased earnings per share by 8.7% last year. And it has bolstered its earnings per share by 3.5% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. 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).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
How Does Canadian Western Bank's Debt Impact Its P/E Ratio?
The extra options and safety that comes with Canadian Western Bank's CA$47m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Canadian Western Bank's P/E Ratio
Canadian Western Bank has a P/E of 10.4. That's below the average in the CA market, which is 15.8. Recent earnings growth wasn't bad. And the net cash position gives the company many options. So it's strange that the low P/E indicates low expectations.
Investors have an opportunity when market expectations about a stock are wrong. 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 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 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.
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