This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Paychex, Inc.'s (NASDAQ:PAYX) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Paychex has a P/E ratio of 28.23. That means that at current prices, buyers pay $28.23 for every $1 in trailing yearly profits.
How Do I Calculate Paychex's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Paychex:
P/E of 28.23 = $84.81 ÷ $3.00 (Based on the year to November 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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.
Does Paychex Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Paychex has a lower P/E than the average (31.2) in the it industry classification.
This suggests that market participants think Paychex will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. 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. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Paychex's earnings per share were pretty steady over the last year. But over the longer term (5 years) earnings per share have increased by 11%.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 Paychex's Debt Impact Its P/E Ratio?
Paychex's net debt is 0.7% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Verdict On Paychex's P/E Ratio
Paychex has a P/E of 28.2. That's higher than the average in its market, which is 18.8. Given the debt is only modest, and earnings are already moving in the right direction, it's not surprising that the market expects continued improvement.
Investors should be looking to buy stocks that the market is wrong about. 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.
You might be able to find a better buy than Paychex. 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 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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