Risks To Shareholder Returns Are Elevated At These Prices For Softcat plc (LON:SCT)

With a price-to-earnings (or "P/E") ratio of 29.5x Softcat plc (LON:SCT) may be sending very bearish signals at the moment, given that almost half of all companies in the United Kingdom have P/E ratios under 17x and even P/E's lower than 10x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

Softcat certainly has been doing a good job lately as it's been growing earnings more than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.

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Does Growth Match The High P/E?

In order to justify its P/E ratio, Softcat would need to produce outstanding growth well in excess of the market.

Retrospectively, the last year delivered a decent 4.5% gain to the company's bottom line. The solid recent performance means it was also able to grow EPS by 27% in total over the last three years. Accordingly, shareholders would have probably been satisfied with the medium-term rates of earnings growth.

Shifting to the future, estimates from the twelve analysts covering the company suggest earnings should grow by 7.5% each year over the next three years. That's shaping up to be materially lower than the 15% per annum growth forecast for the broader market.

In light of this, it's alarming that Softcat's P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. Only the boldest would assume these prices are sustainable as this level of earnings growth is likely to weigh heavily on the share price eventually.

The Final Word

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 Softcat currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

Plus, you should also learn about these 2 warning signs we've spotted with Softcat.

If you're unsure about the strength of Softcat's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.