Cerence (NASDAQ:CRNC) shares have had a really impressive month, gaining 14%, after some slippage. While recent buyers might be laughing, long term holders might not be so pleased, since the recent gain only brings the full year return to evens.
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). The implication here is that deep value investors might steer clear when expectations of a company are too high. 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.
How Does Cerence’s P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 8.90 that sentiment around Cerence isn’t particularly high. If you look at the image below, you can see Cerence has a lower P/E than the average (49.1) in the software industry classification.
Its relatively low P/E ratio indicates that Cerence shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. 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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Cerence’s 222% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Even better, EPS is up 22% per year over three years. So you might say it really deserves to have an above-average P/E ratio.
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
So What Does Cerence’s Balance Sheet Tell Us?
Cerence has net debt worth 18% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Verdict On Cerence’s P/E Ratio
Cerence has a P/E of 8.9. That’s below the average in the US market, which is 14.9. The company does have a little debt, and EPS growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue. What we know for sure is that investors are becoming less uncomfortable about Cerence’s prospects, since they have pushed its P/E ratio from 7.8 to 8.9 over the last month. If you like to buy stocks that could be turnaround opportunities, then this one might be a candidate; but if you’re more sensitive to price, 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 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 Cerence. 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 protected] 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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