Cadence Design Systems (NASDAQ:CDNS) shareholders are no doubt pleased to see that the share price has had a great month, posting a 45% gain, recovering from prior weakness. The full year gain of 24% is pretty reasonable, too.
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). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
Does Cadence Design Systems Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 21.71 that sentiment around Cadence Design Systems isn't particularly high. The image below shows that Cadence Design Systems has a lower P/E than the average (42.2) P/E for companies in the software industry.
This suggests that market participants think Cadence Design Systems will underperform other companies in its industry. Since the market seems unimpressed with Cadence Design Systems, it's quite possible it could surprise on the upside. 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
Earnings growth rates have a big influence on P/E ratios. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Cadence Design Systems's 188% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The cherry on top is that the five year growth rate was an impressive 45% 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
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.
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.
Cadence Design Systems's Balance Sheet
Cadence Design Systems has net cash of US$364m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Cadence Design Systems's P/E Ratio
Cadence Design Systems has a P/E of 21.7. That's higher than the average in its market, which is 13.2. 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 Cadence Design Systems over the last month, with the P/E ratio rising from 15.0 back then to 21.7 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. 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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.
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