To the annoyance of some shareholders, Insperity (NYSE:NSP) shares are down a considerable 32% in the last month. The recent drop has obliterated the annual return, with the share price now down 18% over that longer period.
All else being equal, a share price drop should make a stock more 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). The implication here is that long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Insperity Have A Relatively High Or Low P/E For Its Industry?
Insperity’s P/E of 22.55 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (19) for companies in the professional services industry is lower than Insperity’s P/E.
That means that the market expects Insperity will outperform other companies in its industry.
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. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Insperity’s 53% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The cherry on top is that the five year growth rate was an impressive 50% per year. So I’d be surprised if the P/E ratio was not above average.
Remember: P/E Ratios Don’t Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn’t take debt or cash into account. 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).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
How Does Insperity’s Debt Impact Its P/E Ratio?
Since Insperity holds net cash of US$217m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Insperity’s P/E Ratio
Insperity has a P/E of 22.5. That’s higher than the average in its market, which is 17.1. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we’d expect Insperity to have a high P/E ratio. Given Insperity’s P/E ratio has declined from 33.3 to 22.5 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who don’t like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Insperity. So you may wish to see this free collection of other companies that have grown earnings strongly.
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If you spot an error that warrants correction, please contact the editor at email@example.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.