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With a price-to-earnings (or "P/E") ratio of 28.7x Cerence Inc. (NASDAQ:CRNC) 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 19x and even P/E's lower than 10x 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.
Cerence certainly has been doing a good job lately as its earnings growth has been positive while most other companies have been seeing their earnings go backwards. 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. If not, then existing shareholders might be a little nervous about the viability of the share price.
View our latest analysis for Cerence
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What Are Growth Metrics Telling Us About The High P/E?
There's an inherent assumption that a company should far outperform the market for P/E ratios like Cerence's to be considered reasonable.
Retrospectively, the last year delivered an exceptional 387% gain to the company's bottom line. The strong recent performance means it was also able to grow EPS by 45% in total over the last three years. So we can start by confirming that the company has done a great job of growing earnings over that time.
Shifting to the future, estimates from the seven analysts covering the company suggest earnings growth is heading into negative territory, declining 24% per year over the next three years. That's not great when the rest of the market is expected to grow by 13% per annum.
With this information, we find it concerning that Cerence is trading at a P/E higher than the market. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. There's a very good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the negative growth outlook.
The Key Takeaway
The price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.
Our examination of Cerence's analyst forecasts revealed that its outlook for shrinking earnings isn't impacting its high P/E anywhere near as much as we would have predicted. When we see a poor outlook with earnings heading backwards, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.