With a price-to-earnings (or "P/E") ratio of 26.4x Paychex, Inc. (NASDAQ:PAYX) may be sending very bearish signals at the moment, given that almost half of all companies in the United States have P/E ratios under 16x and even P/E's lower than 9x are not unusual. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.
With its earnings growth in positive territory compared to the declining earnings of most other companies, Paychex has been doing quite well of late. It seems that many are expecting the company to continue defying the broader market adversity, which has increased investors' willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.
What Are Growth Metrics Telling Us About The High P/E?
Paychex's P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.
Taking a look back first, we see that the company managed to grow earnings per share by a handy 10% last year. The latest three year period has also seen an excellent 57% overall rise in EPS, aided somewhat by its short-term performance. Therefore, it's fair to say the earnings growth recently has been superb for the company.
Looking ahead now, EPS is anticipated to climb by 7.2% each year during the coming three years according to the analysts following the company. Meanwhile, the rest of the market is forecast to expand by 11% per annum, which is noticeably more attractive.
In light of this, it's alarming that Paychex's P/E sits above the majority of other companies. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. Only the boldest would assume these prices are sustainable as this level of earnings growth is likely to weigh heavily on the share price eventually.
The Key Takeaway
We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.
We've established that Paychex currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.
Many other vital risk factors can be found on the company's balance sheet. Our free balance sheet analysis for Paychex with six simple checks will allow you to discover any risks that could be an issue.
Of course, you might also be able to find a better stock than Paychex. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.