Broadcom (NASDAQ:AVGO) shareholders are no doubt pleased to see that the share price has bounced 37% in the last month alone, although it is still down 14% over the last quarter. But shareholders may not all be feeling jubilant, since the share price is still down 17% in the last year.
All else being equal, a sharp share price increase should make a stock less 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. 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.
Does Broadcom Have A Relatively High Or Low P/E For Its Industry?
Broadcom's P/E of 41.71 indicates some degree of optimism towards the stock. As you can see below, Broadcom has a higher P/E than the average company (29.6) in the semiconductor industry.
Its relatively high P/E ratio indicates that Broadcom shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Broadcom shrunk earnings per share by 60% over the last year. But EPS is up 26% over the last 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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 Broadcom's Debt Impact Its P/E Ratio?
Broadcom has net debt equal to 36% of its market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On Broadcom's P/E Ratio
Broadcom's P/E is 41.7 which is way above average (13.6) in its market. With some debt but no EPS growth last year, the market has high expectations of future profits. What is very clear is that the market has become significantly more optimistic about Broadcom over the last month, with the P/E ratio rising from 30.5 back then to 41.7 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Broadcom 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).
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.
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. Thank you for reading.