Should You Be Tempted To Sell Constellation Software Inc. (TSE:CSU) Because Of Its P/E Ratio?

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Constellation Software Inc.'s (TSE:CSU) P/E ratio could help you assess the value on offer. Constellation Software has a price to earnings ratio of 49.22, based on the last twelve months. That means that at current prices, buyers pay CA$49.22 for every CA$1 in trailing yearly profits.

View our latest analysis for Constellation Software

How Do You Calculate Constellation Software's P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for Constellation Software:

P/E of 49.22 = $890.33 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $18.09 (Based on the trailing twelve months to March 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Constellation Software increased earnings per share by a whopping 45% last year. And earnings per share have improved by 33% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

Does Constellation Software Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Constellation Software has a higher P/E than the average (28.6) P/E for companies in the software industry.

Constellation Software'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 further research is always essential. I often monitor director buying and selling.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

Don't forget that the P/E ratio considers market capitalization. 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).

How Does Constellation Software's Debt Impact Its P/E Ratio?

Since Constellation Software holds net cash of US$394m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On Constellation Software's P/E Ratio

Constellation Software trades on a P/E ratio of 49.2, which is multiples above the CA market average of 15. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Constellation Software to have a high P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than Constellation Software. 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 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.