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Why Countplus Limited's (ASX:CUP) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Countplus Limited's (ASX:CUP) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Countplus's P/E ratio is 70.91. That means that at current prices, buyers pay A$70.91 for every A$1 in trailing yearly profits.

View our latest analysis for Countplus

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Countplus:

P/E of 70.91 = A$1.05 ÷ A$0.01 (Based on the year to June 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each A$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.

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

We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Countplus has a much higher P/E than the average company (20.5) in the professional services industry.

ASX:CUP Price Estimation Relative to Market, October 7th 2019

Countplus's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. 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.

It's nice to see that Countplus grew EPS by a stonking 27% in the last year. Unfortunately, earnings per share are down 32% a year, over 5 years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

Countplus's Balance Sheet

Since Countplus holds net cash of AU$8.5m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On Countplus's P/E Ratio

With a P/E ratio of 70.9, Countplus is expected to grow earnings very strongly in the years to come. With cash in the bank the company has plenty of growth options -- and it is already on the right track. Therefore it seems reasonable that the market would have relatively high expectations of the company

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 report on the analyst consensus forecasts could help you make a master move on this stock.

But note: Countplus may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.