Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Automatic Data Processing, Inc.'s (NASDAQ:ADP) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Automatic Data Processing has a P/E ratio of 30.36. That means that at current prices, buyers pay $30.36 for every $1 in trailing yearly profits.
How Do You Calculate Automatic Data Processing's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Automatic Data Processing:
P/E of 30.36 = $160.04 ÷ $5.27 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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.
How Does Automatic Data Processing's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (36.5) 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. Since the market seems unimpressed with Automatic Data Processing, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Most would be impressed by Automatic Data Processing earnings growth of 23% in the last year. And earnings per share have improved by 15% annually, over the last five years. So one might expect an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Automatic Data Processing's Balance Sheet
Automatic Data Processing's net debt is 0.4% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Bottom Line On Automatic Data Processing's P/E Ratio
Automatic Data Processing has a P/E of 30.4. That's higher than the average in its market, which is 17.7. Its debt levels do not imperil its balance sheet and it is growing EPS strongly. Therefore, it's not particularly surprising that it has a above average P/E ratio.
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.
You might be able to find a better buy than Automatic Data Processing. 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).
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.