I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Evolving Systems Inc (NASDAQ:EVOL) trades with a trailing P/E of 16.8x, which is lower than the industry average of 41.2x. While EVOL 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.
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for EVOL
Price per share = $2.85
Earnings per share = $0.169
∴ Price-Earnings Ratio = $2.85 ÷ $0.169 = 16.8x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to EVOL, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 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.
Since EVOL’s P/E of 16.8x is lower than its industry peers (41.2x), it means that investors are paying less than they should for each dollar of EVOL’s earnings. This multiple is a median of profitable companies of 25 Software companies in US including IBSG International, Dragon Capital Group and SofTech. As such, our analysis shows that EVOL represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy EVOL immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to EVOL. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with EVOL, then investors would naturally value EVOL at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with EVOL, investors would also value EVOL at a lower price since it is a lower growth investment. Both scenarios would explain why EVOL has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing EVOL to are fairly valued by the market. If this assumption does not hold true, EVOL’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of EVOL to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 EVOL’s future growth? Take a look at our free research report of analyst consensus for EVOL’s outlook.
- Past Track Record: Has EVOL 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 EVOL’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.