Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at PacWest Bancorp's ( NASDAQ:PACW ) P/E ratio and reflect on what it tells us about the company's share price. What is PacWest Bancorp's P/E ratio? Well, based on the last twelve months it is 10.37. That is equivalent to an earnings yield of about 9.6%.
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 PacWest Bancorp:
P/E of 10.37 = $38.61 ÷ $3.72 (Based on the year to December 2018.)
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 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 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. Then, a lower P/E should attract more buyers, pushing the share price up.
PacWest Bancorp increased earnings per share by a whopping 28% last year. And its annual EPS growth rate over 5 years is 28%. I'd therefore be a little surprised if its P/E ratio was not relatively high.
Does PacWest Bancorp Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (12.9) for companies in the banks industry is higher than PacWest Bancorp's P/E.
PacWest Bancorp's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with PacWest Bancorp, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling .
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.
So What Does PacWest Bancorp's Balance Sheet Tell Us?
Net debt is 33% of PacWest Bancorp's market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Bottom Line On PacWest Bancorp's P/E Ratio
PacWest Bancorp has a P/E of 10.4. That's below the average in the US market, which is 17.9. The EPS growth last year was strong, and debt levels are quite reasonable. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
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. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: PacWest Bancorp may not be the best stock to buy . So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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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.