Adobe's (NASDAQ:ADBE) Growth needs to Re-accelerate soon or Valuation will be at Risk

Adobe Inc’s ( NASDAQ:ADBE ) first quarter results were released on Tuesday and resulted in a sharp decline in the stock price. Revenue and earnings for the quarter were slightly better than expected, but the market was concerned by the weak guidance for the current quarter.

First quarter financial highlights:

• Revenue reached a record $4.26 bln, up 9% and $23.8 mln better than expected.
• Normalized EPS of $3.37 was up 7.3% from a year ago and slightly better than expected. 
• GAAP EPS of $2.66 was up 1.9% from a year ago and slightly lower than expected.
• Digital Media segment : Revenue up 9% and ARR up $418 mln to $12.57 bln.
• Digital Experiences segment: Revenue up 13% and subscription revenue up 15%.
• ARR reduced by $75mln due to war in Ukraine

Second Quarter Guidance:

• Revenue $4.34 bln vs $4.4 bln expected
• EPS $3.30 vs $3.35 expected 

Adobe typically beats consensus estimates quite comfortably, and while these results were ahead of estimates the margin was smaller than usual. It was also the slowest revenue growth rate of the last 12 quarters.

Does Growth Match The High P/E?

Adobe’s current  price-to-earnings (or "P/E") ratio of 41.3x is significantly higher than the market average of 16.3x. Typically, when a stock has a P/E ratio that is much higher than the market, it implies investors believe the company’s earnings growth will outperform in the future. 

View our latest analysis for Adobe

How Is Adobe's Growth Trending?

Over the last five years Adobe increased EPS by 27.7% a year, almost double the market’s EPS growth of 13.9% a year. If that outperformance continues, the higher P/E ratio is probably justified. But growth for the last quarter and guidance for the current quarter suggests that growth is either slowing or pausing.

Ahead of these results, analysts were expecting EPS and revenue to grow by 15.9% and 13.3% respectively over the next few years. These growth rates are only slightly higher than expectations for the broader market. It’s also possible that estimates will be revised lower as analysts revisit their models.

What We Can Learn From Adobe's P/E?

We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations. The current P/E ratio would usually suggest the market is quite optimistic about Adobe’s future growth. This doesn’t mean the share price will fall further, but if earnings and guidance don’t recover soon it may be difficult for investors to justify the current price.

As we pointed out in February, Adobe has some excellent underlying business fundamentals . In particular, Adobe has excellent margins and returns on both equity and capital employed. It seems that sales growth is now slowing after a very strong five year run. It's quite common for companies that are good long term performers to go through occasional periods with lower growth. 

The weaker guidance isn’t necessarily a concern for long term investors. However, there may be further underperformance as the high P/E multiple unwinds, or the share price may remain flat until the fundamentals catch up with the valuation. 

We would suggest keeping an eye on analyst forecasts which will be updated on our Adobe analysis page .

It's important to make sure you look for a great company, not just the first idea you come across . So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20x).

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Simply Wall St analyst Richard Bowman and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.