Automatic Data Processing, Inc.'s (NASDAQ:ADP) Share Price Could Signal Some Risk

With a price-to-earnings (or "P/E") ratio of 27.6x Automatic Data Processing, Inc. (NASDAQ:ADP) may be sending very bearish signals at the moment, given that almost half of all companies in the United States have P/E ratios under 17x and even P/E's lower than 10x are not unusual. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's so lofty.

Recent times have been pleasing for Automatic Data Processing as its earnings have risen in spite of the market's earnings going into reverse. It seems that many are expecting the company to continue defying the broader market adversity, which has increased investors’ willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

See our latest analysis for Automatic Data Processing

Is There Enough Growth For Automatic Data Processing?

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

Retrospectively, the last year delivered a decent 14% gain to the company's bottom line. The latest three year period has also seen an excellent 56% overall rise in EPS, aided somewhat by its short-term performance. Therefore, it's fair to say the earnings growth recently has been superb for the company.

Turning to the outlook, the next three years should generate growth of 8.2% per annum as estimated by the analysts watching the company. With the market predicted to deliver 10% growth each year, the company is positioned for a comparable earnings result.

In light of this, it's curious that Automatic Data Processing's P/E sits above the majority of other companies. Apparently many investors in the company are more bullish than analysts indicate and aren't willing to let go of their stock right now. These shareholders may be setting themselves up for disappointment if the P/E falls to levels more in line with the growth outlook.

What We Can Learn From Automatic Data Processing's P/E?

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

We've established that Automatic Data Processing currently trades on a higher than expected P/E since its forecast growth is only in line with the wider market. When we see an average earnings outlook with market-like growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

A lot of potential risks can sit within a company's balance sheet. Take a look at our free balance sheet analysis for Automatic Data Processing with six simple checks on some of these key factors.

Of course, you might also be able to find a better stock than Automatic Data Processing. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com