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To the annoyance of some shareholders, Bright Horizons Family Solutions (NYSE:BFAM) shares are down a considerable 32% in the last month. Even longer term holders have taken a real hit with the stock declining 6.4% in the last year.
All else being equal, a share price drop should make a stock more attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
Does Bright Horizons Family Solutions Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 37.87 that there is some investor optimism about Bright Horizons Family Solutions. The image below shows that Bright Horizons Family Solutions has a higher P/E than the average (25.4) P/E for companies in the consumer services industry.
Bright Horizons Family Solutions's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and 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. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Bright Horizons Family Solutions increased earnings per share by an impressive 14% over the last twelve months. And earnings per share have improved by 23% annually, over the last five years. This could arguably justify a relatively high P/E ratio.
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. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
Bright Horizons Family Solutions's Balance Sheet
Bright Horizons Family Solutions's net debt is 15% of its market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Bottom Line On Bright Horizons Family Solutions's P/E Ratio
Bright Horizons Family Solutions trades on a P/E ratio of 37.9, which is above its market average of 13.3. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. Therefore, it's not particularly surprising that it has a above average P/E ratio. What can be absolutely certain is that the market has become significantly less optimistic about Bright Horizons Family Solutions over the last month, with the P/E ratio falling from 55.4 back then to 37.9 today. 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.
Investors should be looking to buy stocks that the market is wrong about. 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.
You might be able to find a better buy than Bright Horizons Family Solutions. 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).
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.
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