This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
F5 Networks Inc (NASDAQ:FFIV) is currently trading at a trailing P/E of 23.2x, which is lower than the industry average of 32.6x. While FFIV might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 FFIV
Price-Earnings Ratio = Price per share ÷ Earnings per share
FFIV Price-Earnings Ratio = $171.47 ÷ $7.406 = 23.2x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as FFIV, 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. FFIV’s P/E of 23.2 is lower than its industry peers (32.6), which implies that each dollar of FFIV’s earnings is being undervalued by investors. 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. One could put it like this: the market is pricing FFIV as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to FFIV. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with FFIV, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing FFIV to are fairly valued by the market. If this does not hold, there is a possibility that FFIV’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on FFIV, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. 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:
- Future Outlook: What are well-informed industry analysts predicting for FFIV’s future growth? Take a look at our free research report of analyst consensus for FFIV’s outlook.
- Past Track Record: Has FFIV 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 FFIV’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 firstname.lastname@example.org.