EPAM Systems Inc (NYSE:EPAM) is currently trading at a trailing P/E of 40.2x, which is higher than the industry average of 28.5x. While EPAM might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for EPAM Systems
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 EPAM
Price-Earnings Ratio = Price per share ÷ Earnings per share
EPAM Price-Earnings Ratio = 87.93 ÷ 2.187 = 40.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to EPAM, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since EPAM's P/E of 40.2x is higher than its industry peers (28.5x), it means that investors are paying more than they should for each dollar of EPAM's earnings. Therefore, according to this analysis, EPAM is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that EPAM should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to EPAM, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with EPAM, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing EPAM to are fairly valued by the market. If this does not hold true, EPAM’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? 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 EPAM. 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.
Are you a potential investor? If you are considering investing in EPAM, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on EPAM Systems for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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.