Amdocs Limited (NASDAQ:DOX) is currently trading at a trailing P/E of 22.2x, which is lower than the industry average of 23.8x. While this makes DOX appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Amdocs
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for DOX
Price per share = $68.49
Earnings per share = $3.082
∴ Price-Earnings Ratio = $68.49 ÷ $3.082 = 22.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as DOX, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
DOX’s P/E of 22.2x is lower than its industry peers (23.8x), which implies that each dollar of DOX’s earnings is being undervalued by investors. As such, our analysis shows that DOX represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy DOX, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to DOX. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing lower risk firms with DOX, then DOX’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with DOX. In this case, DOX’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DOX to are fairly valued by the market. If this does not hold, there is a possibility that DOX’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on DOX, 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 DOX’s future growth? Take a look at our free research report of analyst consensus for DOX’s outlook.
- Past Track Record: Has DOX 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 DOX’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.