This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Arista Networks, Inc.'s (NYSE:ANET) P/E ratio and reflect on what it tells us about the company's share price. Arista Networks has a price to earnings ratio of 18.92, based on the last twelve months. That means that at current prices, buyers pay $18.92 for every $1 in trailing yearly profits.
How Do You Calculate Arista Networks's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Arista Networks:
P/E of 18.92 = $191.23 ÷ $10.11 (Based on the year to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Arista Networks Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Arista Networks has a P/E ratio that is roughly in line with the communications industry average (20.3).
That indicates that the market expects Arista Networks will perform roughly in line with other companies in its industry. So if Arista Networks actually outperforms its peers going forward, that should be a positive for the share price. I would further inform my view by checking insider buying and selling., among other things.
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. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
In the last year, Arista Networks grew EPS like Taylor Swift grew her fan base back in 2010; the 187% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 53% per year. So I'd be surprised if the P/E ratio was not above average.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
So What Does Arista Networks's Balance Sheet Tell Us?
Arista Networks has net cash of US$2.4b. This is fairly high at 17% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Verdict On Arista Networks's P/E Ratio
Arista Networks's P/E is 18.9 which is about average (18.4) in the US market. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect Arista Networks to have a higher P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Arista Networks. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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