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Despite Its High P/E Ratio, Is Arista Networks, Inc. (NYSE:ANET) Still Undervalued?

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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Arista Networks, Inc.'s (NYSE:ANET) P/E ratio to inform your assessment of the investment opportunity. Arista Networks has a price to earnings ratio of 51.6, based on the last twelve months. In other words, at today's prices, investors are paying $51.6 for every $1 in prior year profit.

View our latest analysis for Arista Networks

How Do I Calculate Arista Networks's Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Arista Networks:

P/E of 51.6 = $263.63 ÷ $5.11 (Based on the trailing twelve months to March 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Arista Networks saw earnings per share decrease by 23% last year. But it has grown its earnings per share by 43% per year over the last five years.

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

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Arista Networks has a higher P/E than the average (27.7) P/E for companies in the communications industry.

NYSE:ANET Price Estimation Relative to Market, June 6th 2019

Arista Networks's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.

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

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).

Is Debt Impacting Arista Networks's P/E?

Arista Networks has net cash of US$2.0b. This is fairly high at 10% 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 Bottom Line On Arista Networks's P/E Ratio

Arista Networks trades on a P/E ratio of 51.6, which is above the US market average of 17.4. The recent drop in earnings per share would make some investors cautious, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.

Investors have an opportunity when market expectations about a stock are wrong. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Arista Networks may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Thank you for reading.