It's really great to see that even after a strong run, Objective (ASX:OCL) shares have been powering on, with a gain of 32% in the last thirty days. Zooming out, the annual gain of 132% knocks our socks off.
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). So some would prefer to hold off buying when there is a lot of optimism towards a stock. 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.
Does Objective Have A Relatively High Or Low P/E For Its Industry?
Objective's P/E of 60.61 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (35.4) for companies in the software industry is lower than Objective's P/E.
Its relatively high P/E ratio indicates that Objective shareholders think it will perform better than other companies in its industry classification. 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
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 unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Objective increased earnings per share by an impressive 22% over the last twelve months. And earnings per share have improved by 10% annually, over the last five years. This could arguably justify a relatively high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
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.
How Does Objective's Debt Impact Its P/E Ratio?
The extra options and safety that comes with Objective's AU$35m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Objective's P/E Ratio
With a P/E ratio of 60.6, Objective is expected to grow earnings very strongly in the years to come. With cash in the bank the company has plenty of growth options -- and it is already on the right track. So it does not seem strange that the P/E is above average. What we know for sure is that investors have become much more excited about Objective recently, since they have pushed its P/E ratio from 46.1 to 60.6 over the last month. 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. 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. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Objective. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.
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