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A Rising Share Price Has Us Looking Closely At Praemium Limited's (ASX:PPS) P/E Ratio

Simply Wall St

Praemium (ASX:PPS) shareholders are no doubt pleased to see that the share price has bounced 31% in the last month alone, although it is still down 11% over the last quarter. Longer term shareholders are no doubt thankful for the recovery in the share price, since it's pretty much flat for the year, even after the recent pop.

Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.

See our latest analysis for Praemium

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

Praemium's P/E of 55.61 indicates some degree of optimism towards the stock. The image below shows that Praemium has a higher P/E than the average (37.7) P/E for companies in the software industry.

ASX:PPS Price Estimation Relative to Market May 22nd 2020

That means that the market expects Praemium will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Praemium's 97% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive.

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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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).

Praemium's Balance Sheet

With net cash of AU$15m, Praemium has a very strong balance sheet, which may be important for its business. Having said that, at 10% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Praemium's P/E Ratio

Praemium's P/E is 55.6 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Praemium to have a high P/E ratio. What we know for sure is that investors have become much more excited about Praemium recently, since they have pushed its P/E ratio from 42.6 to 55.6 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 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

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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. Thank you for reading.