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Intelligent Systems (NYSEMKT:INS) shareholders are no doubt pleased to see that the share price has had a great month, posting a 43% gain, recovering from prior weakness. Zooming out, the annual gain of 300% knocks our socks off.
All else being equal, a sharp share price increase should make a stock less 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 deep value investors might steer clear when expectations of a company are too high. 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.
How Does Intelligent Systems’s P/E Ratio Compare To Its Peers?
Intelligent Systems’s P/E of 44.51 indicates relatively low sentiment towards the stock. If you look at the image below, you can see Intelligent Systems has a lower P/E than the average (53.9) in the software industry classification.
This suggests that market participants think Intelligent Systems will underperform other companies in its industry.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. When earnings grow, the ‘E’ increases, over time. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Intelligent Systems’s earnings made like a rocket, taking off 316% last year. The sweetener is that the annual five year growth rate of 70% is also impressive. So I’d be surprised if the P/E ratio was not above average.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. So it won’t reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 Intelligent Systems’s Debt Impact Its P/E Ratio?
Since Intelligent Systems holds net cash of US$22m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Intelligent Systems’s P/E Ratio
Intelligent Systems trades on a P/E ratio of 44.5, which is above its market average of 18. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we’d expect Intelligent Systems to have a high P/E ratio. What is very clear is that the market has become significantly more optimistic about Intelligent Systems over the last month, with the P/E ratio rising from 31.1 back then to 44.5 today. If you like to buy stocks that have recently impressed the market, then this one might be a candidate; but if you prefer to invest when there is ‘blood in the streets’, then you may feel the opportunity has passed.
Investors have an opportunity when market expectations about a stock are wrong. 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.’ We don’t have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
You might be able to find a better buy than Intelligent Systems. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.