To the annoyance of some shareholders, Genpact (NYSE:G) shares are down a considerable 42% in the last month. The recent drop has obliterated the annual return, with the share price now down 26% over that longer period.
All else being equal, a share price drop should make a stock more attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
How Does Genpact’s P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 15.76 that sentiment around Genpact isn’t particularly high. We can see in the image below that the average P/E (23.3) for companies in the it industry is higher than Genpact’s P/E.
Genpact’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Genpact, it’s quite possible it could surprise on the upside. You should delve deeper.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Genpact increased earnings per share by 8.4% last year. And it has bolstered its earnings per share by 13% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Genpact’s Balance Sheet
Net debt totals 20% of Genpact’s market cap. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.
The Verdict On Genpact’s P/E Ratio
Genpact trades on a P/E ratio of 15.8, which is above its market average of 12.2. With modest debt relative to its size, and modest earnings growth, the market is likely expecting sustained long-term growth, if not a near-term improvement. Given Genpact’s P/E ratio has declined from 27.4 to 15.8 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who don’t like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated.