This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how PacWest Bancorp's (NASDAQ:PACW) P/E ratio could help you assess the value on offer. PacWest Bancorp has a P/E ratio of 9.29, based on the last twelve months. That corresponds to an earnings yield of approximately 10.8%.
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 PacWest Bancorp:
P/E of 9.29 = $35.91 ÷ $3.87 (Based on the year to June 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. 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 PacWest Bancorp'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. We can see in the image below that the average P/E (12.4) for companies in the banks industry is higher than PacWest Bancorp's P/E.
This suggests that market participants think PacWest Bancorp will underperform other companies in its industry. Since the market seems unimpressed with PacWest Bancorp, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Most would be impressed by PacWest Bancorp earnings growth of 16% in the last year. And it has bolstered its earnings per share by 29% per year over the last five years. So one might expect an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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 PacWest Bancorp's Debt Impact Its P/E Ratio?
Net debt is 45% of PacWest Bancorp's market cap. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On PacWest Bancorp's P/E Ratio
PacWest Bancorp's P/E is 9.3 which is below average (17.6) in the US market. The company does have a little debt, and EPS growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
Investors should be looking to buy stocks that the market is wrong about. 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. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than PacWest Bancorp. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.