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When close to half the companies in New Zealand have price-to-earnings ratios (or "P/E's") below 18x, you may consider Solution Dynamics Limited (NZSE:SDL) as a stock to avoid entirely with its 34.4x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.
Recent times have been quite advantageous for Solution Dynamics as its earnings have been rising very briskly. The P/E is probably high because investors think this strong earnings growth will be enough to outperform the broader market in the near future. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.
How Does Solution Dynamics' P/E Ratio Compare To Its Industry Peers?
We'd like to see if P/E's within Solution Dynamics' industry might provide some colour around the company's particularly high P/E ratio. It turns out the IT industry in general also has a P/E ratio significantly higher than the market, as the graphic below shows. So we'd say there is merit in the premise that the company's ratio being shaped by its industry at this time. Ordinarily, the majority of companies' P/E's would be lifted firmly by the general conditions within the IT industry. We'd highlight though, the spotlight should be on the anticipated direction of the company's earnings.
Although there are no analyst estimates available for Solution Dynamics, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.
Is There Enough Growth For Solution Dynamics?
There's an inherent assumption that a company should far outperform the market for P/E ratios like Solution Dynamics' to be considered reasonable.
If we review the last year of earnings growth, the company posted a terrific increase of 56%. Still, incredibly EPS has fallen 15% in total from three years ago, which is quite disappointing. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.
Weighing that medium-term earnings trajectory against the broader market's one-year forecast for a contraction of 7.8% shows the market is even less attractive on an annualised basis.
With this information, it might not be hard to see why Solution Dynamics is trading at a higher P/E in comparison. However, even if the company's recent growth rates were to continue outperforming the market, shrinking earnings are unlikely to make the P/E premium sustainable over the longer term. Maintaining these prices will be difficult to achieve as a continuation of recent earnings trends is likely to weigh down the shares eventually.
The Key Takeaway
Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.
As we suspected, our examination of Solution Dynamics revealed its narrower three-year contraction in earnings is contributing to its high P/E, given the market is set to shrink even more. Right now shareholders are comfortable with the P/E as they are quite confident earnings aren't under any additional threat. Our only concern is whether its earnings trajectory can keep outperforming under these tough market conditions. Although, if the company's relative performance doesn't change it will continue to provide strong support to the share price.
We don't want to rain on the parade too much, but we did also find 3 warning signs for Solution Dynamics that you need to be mindful of.
It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20x).
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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