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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use First Capital, Inc.'s (NASDAQ:FCAP) P/E ratio to inform your assessment of the investment opportunity. First Capital has a P/E ratio of 18.8, based on the last twelve months. That is equivalent to an earnings yield of about 5.3%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for First Capital:
P/E of 18.8 = $52.32 ÷ $2.78 (Based on the year to March 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. 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.
Does First Capital Have A Relatively High Or Low P/E For Its Industry?
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
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Most would be impressed by First Capital earnings growth of 15% in the last year. And it has bolstered its earnings per share by 8.4% per year over the last five years. So one might expect an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. 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.
So What Does First Capital's Balance Sheet Tell Us?
With net cash of US$62m, First Capital has a very strong balance sheet, which may be important for its business. Having said that, at 35% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On First Capital's P/E Ratio
First Capital's P/E is 18.8 which is about average (18) in the US market. With a strong balance sheet combined with recent growth, the P/E implies the market is quite pessimistic.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. Although we don't have analyst forecasts, you might want to assess this data-rich visualization of earnings, revenue and cash flow.
Of course you might be able to find a better stock than First Capital. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 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. Thank you for reading.