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Why Northeast Bank's (NASDAQ:NBN) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Northeast Bank's (NASDAQ:NBN), to help you decide if the stock is worth further research. Based on the last twelve months, Northeast Bank's P/E ratio is 14.87. That is equivalent to an earnings yield of about 6.7%.

Check out our latest analysis for Northeast Bank

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 Northeast Bank:

P/E of 14.87 = $23.23 ÷ $1.56 (Based on the year to September 2019.)

Is A High P/E 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 Northeast Bank's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (12.7) for companies in the banks industry is lower than Northeast Bank's P/E.

NasdaqGM:NBN Price Estimation Relative to Market, November 12th 2019

That means that the market expects Northeast Bank will outperform other companies in its industry. 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

Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Northeast Bank shrunk earnings per share by 13% over the last year. But it has grown its earnings per share by 32% per year over the last five years.

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

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

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).

Is Debt Impacting Northeast Bank's P/E?

With net cash of US$39m, Northeast Bank has a very strong balance sheet, which may be important for its business. Having said that, at 18% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Northeast Bank's P/E Ratio

Northeast Bank's P/E is 14.9 which is below average (18.2) in the US market. Falling earnings per share are likely to be keeping potential buyers away, but the net cash position means the company has time to improve: if so, the low P/E could be an opportunity.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

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.