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Is Cadence Design Systems, Inc.'s (NASDAQ:CDNS) P/E Ratio Really That Good?

Simply Wall St

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Cadence Design Systems, Inc.'s (NASDAQ:CDNS), to help you decide if the stock is worth further research. Cadence Design Systems has a P/E ratio of 43.13, based on the last twelve months. In other words, at today's prices, investors are paying $43.13 for every $1 in prior year profit.

Check out our latest analysis for Cadence Design Systems

How Do You Calculate Cadence Design Systems's P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Cadence Design Systems:

P/E of 43.13 = $67.11 ÷ $1.56 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

Does Cadence Design Systems Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. The image below shows that Cadence Design Systems has a lower P/E than the average (48.4) P/E for companies in the software industry.

NasdaqGS:CDNS Price Estimation Relative to Market, August 28th 2019

Cadence Design Systems's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

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.

In the last year, Cadence Design Systems grew EPS like Taylor Swift grew her fan base back in 2010; the 98% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 27% per year. So I'd be surprised if the P/E ratio was not above average.

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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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).

How Does Cadence Design Systems's Debt Impact Its P/E Ratio?

The extra options and safety that comes with Cadence Design Systems's US$288m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On Cadence Design Systems's P/E Ratio

Cadence Design Systems's P/E is 43.1 which is above average (17) in its market. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Cadence Design Systems to have a high P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

You might be able to find a better buy than Cadence Design 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 editorial-team@simplywallst.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.