A Rising Share Price Has Us Looking Closely At VMware, Inc.'s (NYSE:VMW) P/E Ratio

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. 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). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content=" See our latest analysis for VMware ” data-reactid=”21″>See our latest analysis for VMware

Does VMware Have A Relatively High Or Low P/E For Its Industry?

We can tell from its P/E ratio of 8.69 that sentiment around VMware isn’t particularly high. We can see in the image below that the average P/E (43.4) for companies in the software industry is higher than VMware’s P/E.

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<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="VMware's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.” data-reactid=”36″>VMware’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

VMware’s 286% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The cherry on top is that the five year growth rate was an impressive 49% per year. With that kind of growth rate we would generally expect a high P/E ratio.

Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits

Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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.

Is Debt Impacting VMware’s P/E?

VMware’s net debt is 5.1% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Verdict On VMware’s P/E Ratio

VMware’s P/E is 8.7 which is below average (13.5) in the US market. The company hasn’t stretched its balance sheet, and earnings 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 is very clear is that the market has become less pessimistic about VMware over the last month, with the P/E ratio rising from 6.2 back then to 8.7 today. For those who like to invest in turnarounds, that might mean it’s time to put the stock on a watchlist, or research it. But others might consider the opportunity to have passed.