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Despite Its High P/E Ratio, Is Softcat plc (LON:SCT) Still Undervalued?

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 look at Softcat plc's (LON:SCT) P/E ratio and reflect on what it tells us about the company's share price. What is Softcat's P/E ratio? Well, based on the last twelve months it is 31.79. That is equivalent to an earnings yield of about 3.1%.

See our latest analysis for Softcat

How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for Softcat:

P/E of 31.79 = £11.01 ÷ £0.35 (Based on the trailing twelve months to July 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. 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 Softcat Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (27.4) for companies in the it industry is lower than Softcat's P/E.

LSE:SCT Price Estimation Relative to Market, December 9th 2019

Softcat's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

It's great to see that Softcat grew EPS by 24% in the last year. And its annual EPS growth rate over 3 years is 27%. With that performance, you might expect an above average P/E ratio.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

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 Softcat's Debt Impact Its P/E Ratio?

Softcat has net cash of UK£79m. 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 Softcat's P/E Ratio

Softcat's P/E is 31.8 which is above average (17.3) in its market. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.

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.

But note: Softcat 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 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.