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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 look at First Capital, Inc.'s (NASDAQ:FCAP) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, First Capital has a P/E ratio of 23.37. That means that at current prices, buyers pay $23.37 for every $1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for First Capital:
P/E of 23.37 = $73.09 ÷ $3.13 (Based on the trailing twelve months to September 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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 Does First Capital'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. The image below shows that First Capital has a higher P/E than the average (12.9) P/E for companies in the banks industry.
First Capital's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. 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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
First Capital increased earnings per share by an impressive 25% over the last twelve months. And earnings per share have improved by 9.2% annually, over the last five years. With that performance, you might expect an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. 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 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.
How Does First Capital's Debt Impact Its P/E Ratio?
With net cash of US$51m, First Capital has a very strong balance sheet, which may be important for its business. Having said that, at 21% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On First Capital's P/E Ratio
First Capital trades on a P/E ratio of 23.4, which is above its market average of 18.8. With cash in the bank the company has plenty of growth options -- and it is already on the right track. Therefore it seems reasonable that the market would have relatively high expectations of the company
Investors have an opportunity when market expectations about a stock are wrong. 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. Although we don't have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than First Capital. 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.