Applied Materials Inc (NASDAQ:AMAT) is currently trading at a trailing P/E of 20.4x, which is lower than the industry average of 25.6x. While AMAT might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Applied Materials
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for AMAT
Price-Earnings Ratio = Price per share ÷ Earnings per share
AMAT Price-Earnings Ratio = $54.73 ÷ $2.685 = 20.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AMAT, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 20.4x, AMAT’s P/E is lower than its industry peers (25.6x). This implies that investors are undervaluing each dollar of AMAT’s earnings. As such, our analysis shows that AMAT represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy AMAT immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AMAT, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with AMAT, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AMAT to are fairly valued by the market. If this does not hold true, AMAT’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on AMAT, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for AMAT’s future growth? Take a look at our free research report of analyst consensus for AMAT’s outlook.
- Past Track Record: Has AMAT been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of AMAT’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.