Paycom Software (NYSE:PAYC) shareholders are no doubt pleased to see that the share price has bounced 46% in the last month alone, although it is still down 28% over the last quarter. The full year gain of 16% is pretty reasonable, too.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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. Perhaps the simplest way to get a read on investors' expectations of a business 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 Paycom Software's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 70.97 that there is some investor optimism about Paycom Software. You can see in the image below that the average P/E (46.0) for companies in the software industry is lower than Paycom Software's P/E.
That means that the market expects Paycom Software will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Paycom Software increased earnings per share by a whopping 37% last year. And it has bolstered its earnings per share by 76% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Paycom Software's Balance Sheet
Paycom Software has net cash of US$178m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Paycom Software's P/E Ratio
With a P/E ratio of 71.0, Paycom Software is expected to grow earnings very strongly in the years to come. Its net cash position is the cherry on top of its superb EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings). What is very clear is that the market has become significantly more optimistic about Paycom Software over the last month, with the P/E ratio rising from 48.5 back then to 71.0 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. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Paycom Software may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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