Yahoo Finance Should You Be Tempted To Buy Cognizant Technology Solutions Corporation (CTSH) Because Of Its PE Ratio?
Cognizant Technology Solutions Corporation (NASDAQ:CTSH) trades with a trailing P/E of 23x, which is lower than the industry average of 28.5x. While this makes CTSH 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 Cognizant Technology Solutions
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. 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.
P/E Calculation for CTSH
Price-Earnings Ratio = Price per share ÷ Earnings per share
CTSH Price-Earnings Ratio = 72.14 ÷ 3.135 = 23x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CTSH, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. CTSH’s P/E of 23x is lower than its industry peers (28.5x), which implies that each dollar of CTSH’s earnings is being undervalued by investors. As such, our analysis shows that CTSH represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that CTSH is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to CTSH, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CTSH, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing CTSH to are fairly valued by the market. If this does not hold true, CTSH’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on CTSH, 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.
Are you a potential investor? If you are considering investing in CTSH, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Cognizant Technology Solutions for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass 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.
