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Why AU Small Finance Bank Limited's (NSE:AUBANK) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

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 AU Small Finance Bank Limited's (NSE:AUBANK) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, AU Small Finance Bank has a P/E ratio of 38.55. That means that at current prices, buyers pay ₹38.55 for every ₹1 in trailing yearly profits.

Check out our latest analysis for AU Small Finance Bank

How Do I Calculate AU Small Finance Bank's Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for AU Small Finance Bank:

P/E of 38.55 = ₹654.30 ÷ ₹16.97 (Based on the year to June 2019.)

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 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 AU Small Finance Bank'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. You can see in the image below that the average P/E (20.1) for companies in the banks industry is lower than AU Small Finance Bank's P/E.

NSEI:AUBANK Price Estimation Relative to Market, October 20th 2019

AU Small Finance Bank'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 investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. 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.

In the last year, AU Small Finance Bank grew EPS like Taylor Swift grew her fan base back in 2010; the 58% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 33% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. 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.

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.

AU Small Finance Bank's Balance Sheet

Net debt is 39% of AU Small Finance Bank's market cap. While that's enough to warrant consideration, it doesn't really concern us.

The Bottom Line On AU Small Finance Bank's P/E Ratio

AU Small Finance Bank has a P/E of 38.6. That's higher than the average in its market, which is 13.3. Its debt levels do not imperil its balance sheet and its EPS growth is very healthy indeed. So to be frank we are not surprised it has a high P/E ratio.

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 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.

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 editorial-team@simplywallst.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.