U.S. Markets closed

Does Zynga Inc’s (NASDAQ:ZNGA) PE Ratio Warrant A Sell?

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 better understand how you can grow your money by investing in Zynga Inc (NASDAQ:ZNGA).

Zynga Inc (NASDAQ:ZNGA) is trading with a trailing P/E of 87.3x, which is higher than the industry average of 37x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.

What you need to know about the P/E ratio

P/E is a popular ratio used for relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for ZNGA

Price-Earnings Ratio = Price per share ÷ Earnings per share

ZNGA Price-Earnings Ratio = \$4.2 ÷ \$0.0481 = 87.3x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ZNGA, 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. ZNGA’s P/E of 87.3x is higher than its industry peers (37x), which implies that each dollar of ZNGA’s earnings is being overvalued by investors. Therefore, according to this analysis, ZNGA is an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that ZNGA should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to ZNGA. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with ZNGA, 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 ZNGA to are fairly valued by the market. If this is violated, ZNGA’s P/E may be lower than its peers as they are actually overvalued by investors.

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 ZNGA. 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 urge you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for ZNGA’s future growth? Take a look at our free research report of analyst consensus for ZNGA’s outlook.
2. Past Track Record: Has ZNGA 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 ZNGA’s historicals for more clarity.
3. 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.