Automatic Data Processing, Inc.'s (NASDAQ:ADP) price-to-earnings (or "P/E") ratio of 35.4x might make it look like a strong sell right now compared to the market in the United States, where around half of the companies have P/E ratios below 14x and even P/E's below 8x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.
With earnings growth that's superior to most other companies of late, Automatic Data Processing has been doing relatively well. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.
Keen to find out how analysts think Automatic Data Processing's future stacks up against the industry? In that case, our free report is a great place to start.
What Are Growth Metrics Telling Us About The High P/E?
The only time you'd be truly comfortable seeing a P/E as steep as Automatic Data Processing's is when the company's growth is on track to outshine the market decidedly.
If we review the last year of earnings growth, the company posted a worthy increase of 14%. This was backed up an excellent period prior to see EPS up by 34% in total over the last three years. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.
Looking ahead now, EPS is anticipated to climb by 12% per annum during the coming three years according to the analysts following the company. Meanwhile, the rest of the market is forecast to only expand by 9.0% per year, which is noticeably less attractive.
In light of this, it's understandable that Automatic Data Processing's P/E sits above the majority of other companies. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.
The Final Word
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 Automatic Data Processing maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. Unless these conditions change, they will continue to provide strong support to the share price.
Having said that, be aware Automatic Data Processing is showing 1 warning sign in our investment analysis, you should know about.
You might be able to find a better investment than Automatic Data Processing. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a P/E below 20x (but have proven they can grow earnings).
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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.
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