Automatic Data Processing, Inc. (NASDAQ:ADP) stock price could signal risk
With a price/earnings ratio (or “P/E”) of 36.6x Automatic Data Processing, Inc. (NASDAQ:ADP) may be sending very bearish signals right now, given that nearly half of all companies in the US have P/E ratios below 17x and even P/Es below 9x are not not unusual. However, the P/E may be quite high for a reason and it requires further investigation to determine if it is warranted.
Recent times have not been good for automatic data processing, as its profits have grown more slowly than most other companies. One possibility is that the P/E is high because investors believe this lackluster earnings performance will improve significantly. You really hope so, otherwise you pay a pretty high price for no particular reason.
Is the growth sufficient for automatic data processing?
There is an inherent assumption that a company would have to significantly outperform the market for P/E ratios like that of automatic data processing to be considered reasonable.
Looking back, last year provided a decent 9.8% gain in the company’s bottom line. This was supported by an excellent period before seeing EPS increase by 42% in total over the past three years. Therefore, shareholders would likely have welcomed these medium-term earnings growth rates.
Looking ahead, estimates from analysts covering the company suggest earnings are expected to grow 9.8% annually over the next three years. This is shaping up to be similar to the 11% per year growth forecast for the overall market.
With this information, we find it interesting that automatic data processing is trading at a high P/E relative to the market. Apparently, many of the company’s investors are more optimistic than analysts indicate and aren’t willing to give up on their shares just yet. However, further gains will be hard to come by as this level of earnings growth is likely to weigh on the stock price going forward.
The last word
We would argue that the power of the P/E ratio is not primarily a valuation tool, but rather to gauge current investor sentiment and future expectations.
Our review of Automatic Data Processing’s analyst forecasts revealed that its market-matching earnings outlook is not impacting its high P/E as much as we would have expected. When we see an average earnings outlook with market-like growth, we suspect the stock price may decline, driving down the high PER. This puts shareholders’ investments at risk and potential investors risk paying an unnecessary premium.
The company’s balance sheet is another key area for risk analysis. Our free balance sheet analysis for automatic data processing with six simple checks you will discover any hazards that could be a problem.
It’s important to be sure to research a great company, not just the first idea you come across. So take a look at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20x).
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