To the annoyance of some shareholders, Class (ASX:CL1) shares are down a considerable 53% in the last month. That drop has capped off a tough year for shareholders, with the share price down 49% in that time.
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. Perhaps the simplest way to get a read on investors' expectations of a business 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.
How Does Class's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 13.46 that sentiment around Class isn't particularly high. If you look at the image below, you can see Class has a lower P/E than the average (33.6) in the software industry classification.
Class's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
Class's earnings per share fell by 12% in the last twelve months. But EPS is up 16% over the last 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
So What Does Class's Balance Sheet Tell Us?
With net cash of AU$17m, Class has a very strong balance sheet, which may be important for its business. Having said that, at 14% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Class's P/E Ratio
Class has a P/E of 13.5. That's around the same as the average in the AU market, which is 13.3. While the lack of recent growth is probably muting optimism, the relatively strong balance sheet will allow the company to weather a storm; so it isn't very surprising to see that it has a P/E ratio close to the market average. Given Class's P/E ratio has declined from 28.4 to 13.5 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal 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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Class 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 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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