Cerillion (LON:CER) shares have continued recent momentum with a 34% gain in the last month alone. That brought the twelve month gain to a very sharp 82%.
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 Cerillion Have A Relatively High Or Low P/E For Its Industry?
Cerillion has a P/E ratio of 31.78. You can see in the image below that the average P/E (31.4) for companies in the software industry is roughly the same as Cerillion's P/E.
Its P/E ratio suggests that Cerillion shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
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. 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.
Cerillion increased earnings per share by an impressive 20% over the last twelve months. And earnings per share have improved by 82% annually, over the last three years. With that performance, you might expect an above average P/E ratio. But earnings per share are down 74% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Is Debt Impacting Cerillion's P/E?
Cerillion has net cash of UK£5.0m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Cerillion's P/E Ratio
Cerillion has a P/E of 31.8. That's higher than the average in its market, which is 18.2. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it does not seem strange that the P/E is above average. What is very clear is that the market has become significantly more optimistic about Cerillion over the last month, with the P/E ratio rising from 23.7 back then to 31.8 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 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Cerillion 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.