Should We Worry About Align Technology Inc’s (NASDAQ:ALGN) P/E Ratio?
I am writing today to help inform people who are new to 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.
Align Technology Inc (NASDAQ:ALGN) is trading with a trailing P/E of 58.9, which is higher than the industry average of 47.8. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
View our latest analysis for Align Technology
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 ALGN
Price-Earnings Ratio = Price per share ÷ Earnings per share
ALGN Price-Earnings Ratio = $230.13 ÷ $3.908 = 58.9x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ALGN, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since ALGN’s P/E of 58.9 is higher than its industry peers (47.8), it means that investors are paying more for each dollar of ALGN’s earnings. This multiple is a median of profitable companies of 25 Medical Equipment companies in US including Escalon Medical, Lantheus Holdings and FONAR. You could also say that the market is suggesting that ALGN is a stronger business than the average comparable company.
A few caveats
However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to ALGN. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Align Technology Inc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to ALGN may not be 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:
Since you may have already conducted your due diligence on ALGN, the overvaluation of the stock may mean it is a good time to reduce 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 urge you to complete your research by taking a look at the following:
Future Outlook: What are well-informed industry analysts predicting for ALGN’s future growth? Take a look at our free research report of analyst consensus for ALGN’s outlook.
Past Track Record: Has ALGN 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 ALGN’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 editorial-team@simplywallst.com.
