This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Severn Bancorp, Inc.’s (NASDAQ:SVBI) P/E ratio could help you assess the value on offer. Severn Bancorp has a price to earnings ratio of 18.99, based on the last twelve months. That means that at current prices, buyers pay $18.99 for every $1 in trailing yearly profits.
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How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Severn Bancorp:
P/E of 18.99 = $8.35 ÷ $0.44 (Based on the trailing twelve months to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company 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
When earnings fall, the ‘E’ decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Notably, Severn Bancorp grew EPS by a whopping 56% in the last year. And earnings per share have improved by 67% annually, over the last five years. So we’d generally expect it to have a relatively high P/E ratio. But earnings per share are down 15% per year over the last three years.
How Does Severn Bancorp’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (16.1) for companies in the mortgage industry is lower than Severn Bancorp’s P/E.
Its relatively high P/E ratio indicates that Severn Bancorp shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.
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).
How Does Severn Bancorp’s Debt Impact Its P/E Ratio?
Since Severn Bancorp holds net cash of US$6.0m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Severn Bancorp’s P/E Ratio
Severn Bancorp has a P/E of 19. That’s higher than the average in the US market, which is 16.7. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. Therefore it seems reasonable that the market would have relatively high expectations of the company
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. We don’t have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
You might be able to find a better buy than Severn Bancorp. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.