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Is Constellation Software Inc.'s (TSE:CSU) High P/E Ratio A Problem For Investors?

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Constellation Software Inc.'s (TSE:CSU) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Constellation Software's P/E ratio is 49.06. That corresponds to an earnings yield of approximately 2.0%.

Check out our latest analysis for Constellation Software

How Do I Calculate Constellation Software's Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for Constellation Software:

P/E of 49.06 = CA$973.03 (Note: this is the share price in the reporting currency, namely, USD ) ÷ CA$19.83 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each CA$1 of company earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Does Constellation Software's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Constellation Software has a higher P/E than the average company (18.0) in the software industry.

TSX:CSU Price Estimation Relative to Market, January 5th 2020

Constellation Software's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.

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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Constellation Software's 52% 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 32% per year. With that kind of growth rate we would generally expect a high P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

Don't forget that the P/E ratio considers market capitalization. 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.

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.

Constellation Software's Balance Sheet

Net debt totals just 1.0% of Constellation Software's market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.

The Verdict On Constellation Software's P/E Ratio

Constellation Software trades on a P/E ratio of 49.1, which is multiples above its market average of 15.8. While the company does use modest debt, its recent earnings growth is superb. So on this analysis a high P/E ratio seems reasonable.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. 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.

Of course you might be able to find a better stock than Constellation Software. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.

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.