To the annoyance of some shareholders, Paycom Software (NYSE:PAYC) shares are down a considerable 35% in the last month. Indeed, the recent drop has reduced the annual gain to a relatively sedate 5.5% over the last twelve months.
Assuming nothing else has changed, a lower share price makes a stock more attractive to potential buyers. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
How Does Paycom Software’s P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 61.22 that there is some investor optimism about Paycom Software. You can see in the image below that the average P/E (37.1) for companies in the software industry is lower than Paycom Software’s P/E.
That means that the market expects Paycom Software will outperform other companies in its industry. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Notably, Paycom Software grew EPS by a whopping 32% in the last year. And its annual EPS growth rate over 5 years is 94%. I’d therefore be a little surprised if its P/E ratio was not relatively high.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Paycom Software’s Balance Sheet
Since Paycom Software holds net cash of US$101m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Paycom Software’s P/E Ratio
Paycom Software’s P/E is 61.2 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we’d expect Paycom Software to have a high P/E ratio. What can be absolutely certain is that the market has become significantly less optimistic about Paycom Software over the last month, with the P/E ratio falling from 94.5 back then to 61.2 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
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. 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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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