The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
AudioCodes Ltd (NASDAQ:AUDC) trades with a trailing P/E of 43.7, which is higher than the industry average of 32.5. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 AUDC
Price-Earnings Ratio = Price per share ÷ Earnings per share
AUDC Price-Earnings Ratio = $9.66 ÷ $0.221 = 43.7x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AUDC, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 43.7, AUDC’s P/E is higher than its industry peers (32.5). This implies that investors are overvaluing each dollar of AUDC’s earnings. This multiple is a median of profitable companies of 24 Communications companies in US including Ciena, Network-1 Technologies and B.O.S Better Online Solutions. You could think of it like this: the market is pricing AUDC as if it is a stronger company than the average of its industry group.
A few caveats
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to AUDC. If not, the difference in P/E might be a result of other factors. For example, if AudioCodes Ltd is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with AUDC are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to AUDC. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Are AUDC’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has AUDC 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 AUDC’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 past 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. For errors that warrant correction please contact the editor at email@example.com.