Data#3 (ASX:DTL) shareholders are no doubt pleased to see that the share price has had a great month, posting a 39% gain, recovering from prior weakness. Zooming out, the annual gain of 186% knocks our socks off.
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). So some would prefer to hold off buying when there is a lot of optimism towards a stock. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
See our latest analysis for Data#3
Does Data#3 Have A Relatively High Or Low P/E For Its Industry?
Data#3's P/E of 39.78 indicates some degree of optimism towards the stock. As you can see below, Data#3 has a higher P/E than the average company (22.9) in the it industry.
Data#3's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Data#3 increased earnings per share by an impressive 18% over the last twelve months. And its annual EPS growth rate over 5 years is 19%. This could arguably justify a relatively high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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.
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).
So What Does Data#3's Balance Sheet Tell Us?
Since Data#3 holds net cash of AU$23m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Data#3's P/E Ratio
Data#3's P/E is 39.8 which is above average (15.4) in its market. With cash in the bank the company has plenty of growth options -- and it is already on the right track. So it does not seem strange that the P/E is above average. What we know for sure is that investors have become much more excited about Data#3 recently, since they have pushed its P/E ratio from 28.6 to 39.8 over the last month. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
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. 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.
You might be able to find a better buy than Data#3. 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).
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.