Read This Before You Buy Automatic Data Processing, Inc. (NASDAQ:ADP) Because Of Its P/E Ratio

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Automatic Data Processing, Inc.'s (NASDAQ:ADP), to help you decide if the stock is worth further research. Based on the last twelve months, Automatic Data Processing's P/E ratio is 25.72. That corresponds to an earnings yield of approximately 3.9%.

View our latest analysis for Automatic Data Processing

How Do I Calculate Automatic Data Processing's Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Automatic Data Processing:

P/E of 25.72 = $150.680 ÷ $5.858 (Based on the trailing twelve months to March 2020.)

(Note: the above calculation results may not be precise due to rounding.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

Does Automatic Data Processing Have A Relatively High Or Low P/E For Its Industry?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. We can see in the image below that the average P/E (27.8) for companies in the it industry is higher than Automatic Data Processing's P/E.

Its relatively low P/E ratio indicates that Automatic Data Processing shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Notably, Automatic Data Processing grew EPS by a whopping 30% in the last year. And earnings per share have improved by 16% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

So What Does Automatic Data Processing's Balance Sheet Tell Us?

Automatic Data Processing's net debt is 0.5% of its market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Verdict On Automatic Data Processing's P/E Ratio

Automatic Data Processing's P/E is 25.7 which is above average (16.7) in its market. The company is not overly constrained by its modest debt levels, and its recent EPS growth is nothing short of stand-out. So to be frank we are not surprised it has 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 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 Automatic Data Processing. So you may wish to see this free collection of other companies that have grown earnings strongly.

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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. Thank you for reading.