Unfortunately for some shareholders, the Computer Modelling Group (TSE:CMG) share price has dived 36% in the last thirty days. Even longer term holders have taken a real hit with the stock declining 27% in the last year.
All else being equal, a share price drop should make a stock more 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). The implication here is that long term investors have an opportunity when expectations of a company are too low. 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 ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
Does Computer Modelling Group Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 16.02 that there is some investor optimism about Computer Modelling Group. As you can see below, Computer Modelling Group has a higher P/E than the average company (9.5) in the energy services industry.
Its relatively high P/E ratio indicates that Computer Modelling Group 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
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Computer Modelling Group's earnings per share were pretty steady over the last year. And it has shrunk its earnings per share by 7.5% per year over the last five years. So you wouldn't expect a very high P/E.
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. 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.
Is Debt Impacting Computer Modelling Group's P/E?
With net cash of CA$37m, Computer Modelling Group 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 Bottom Line On Computer Modelling Group's P/E Ratio
Computer Modelling Group's P/E is 16.0 which is above average (10.3) in its market. Recent earnings growth wasn't bad. And the net cash position provides the company with multiple options. The high P/E suggests the market thinks further growth will come. What can be absolutely certain is that the market has become significantly less optimistic about Computer Modelling Group over the last month, with the P/E ratio falling from 25.1 back then to 16.0 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
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.
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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