To the annoyance of some shareholders, CDK Global (NASDAQ:CDK) shares are down a considerable 33% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 40% drop over twelve months.
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). So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. One way to gauge market expectations of a stock 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 CDK Global Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 18.36 that sentiment around CDK Global isn't particularly high. If you look at the image below, you can see CDK Global has a lower P/E than the average (33.7) in the software industry classification.
This suggests that market participants think CDK Global will underperform other companies in its industry. Since the market seems unimpressed with CDK Global, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. 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.
CDK Global shrunk earnings per share by 5.3% last year. But EPS is up 8.5% over the last 5 years.
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. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
So What Does CDK Global's Balance Sheet Tell Us?
CDK Global's net debt is 59% of its market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.
The Verdict On CDK Global's P/E Ratio
CDK Global trades on a P/E ratio of 18.4, which is above its market average of 12.7. With relatively high debt, and no earnings per share growth over twelve months, it's safe to say the market believes the company will improve its earnings growth in the future. What can be absolutely certain is that the market has become significantly less optimistic about CDK Global over the last month, with the P/E ratio falling from 27.3 back then to 18.4 today. For those who don't like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.
You might be able to find a better buy than CDK Global. 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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