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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Provident Bancorp, Inc.'s (NASDAQ:PVBC) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Provident Bancorp's P/E ratio is 19.74. That is equivalent to an earnings yield of about 5.1%.
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 Provident Bancorp:
P/E of 19.74 = $11.68 ÷ $0.59 (Based on the trailing twelve months to September 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.
How Does Provident 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. As you can see below, Provident Bancorp has a higher P/E than the average company (14.5) in the mortgage industry.
Provident Bancorp's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
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. Then, a lower P/E should attract more buyers, pushing the share price up.
Notably, Provident Bancorp grew EPS by a whopping 34% in the last year. And earnings per share have improved by 22% annually, over the last three years. So we'd generally expect it to have a relatively high P/E ratio. Unfortunately, earnings per share are down 40% a year, over 5 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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Is Debt Impacting Provident Bancorp's P/E?
Since Provident Bancorp holds net cash of US$9.0m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Provident Bancorp's P/E Ratio
Provident Bancorp's P/E is 19.7 which is above average (18.4) in its market. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Provident Bancorp to have a high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Provident 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).
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.