With a median price-to-earnings (or "P/E") ratio of close to 21x in Germany, you could be forgiven for feeling indifferent about Software Aktiengesellschaft's (ETR:SOW) P/E ratio of 22.1x. While this might not raise any eyebrows, if the P/E ratio is not justified investors could be missing out on a potential opportunity or ignoring looming disappointment.
Software has been struggling lately as its earnings have declined faster than most other companies. One possibility is that the P/E is moderate because investors think the company's earnings trend will eventually fall in line with most others in the market. If you still like the company, you'd want its earnings trajectory to turn around before making any decisions. Or at the very least, you'd be hoping it doesn't keep underperforming if your plan is to pick up some stock while it's not in favour.free report on Software will help you uncover what's on the horizon.
Does Growth Match The P/E?
There's an inherent assumption that a company should be matching the market for P/E ratios like Software's to be considered reasonable.
Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 18%. This means it has also seen a slide in earnings over the longer-term as EPS is down 2.9% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.
Looking ahead now, EPS is anticipated to climb by 0.3% per year during the coming three years according to the analysts following the company. That's shaping up to be materially lower than the 14% per year growth forecast for the broader market.
In light of this, it's curious that Software's P/E sits in line with the majority of other companies. Apparently many investors in the company are less bearish than analysts indicate and aren't willing to let go of their stock right now. These shareholders may be setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.
The Key Takeaway
Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.
We've established that Software currently trades on a higher than expected P/E since its forecast growth is lower than the wider market. Right now we are uncomfortable with the P/E as the predicted future earnings aren't likely to support a more positive sentiment for long. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.
It is also worth noting that we have found 2 warning signs for Software that you need to take into consideration.
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 a strong growth track record, trading on a P/E below 20x.
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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.
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