L3 Technologies Inc (NYSE: LLL) trades at a P/E multiple of 25.0x, which is higher than the Industrials sector median of 22.8x. While this makes LLL appear like a stock to avoid or sell if you own it, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Understanding Valuation Multiples and the P/E Ratio
A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (peer group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Multiple is a valuation ratio that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Multiple = Stock Price ÷ Earnings Per Share
The P/E ratio is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different. I compare L3’s P/E multiple to those of Rockwell Collins, Inc. (NYSE: COL), Spirit Aerosystems Holdings, Inc.(NYSE: SPR), Raytheon Company (NYSE: RTN) and Harris Corporation (NYSE: HRS) in the chart below.
Since L3’s P/E of 25.0x is lower than the median of its peers (29.4x), it means that investors are paying less than they should for each dollar of LLL’s earnings. As such, our analysis shows that LLL represents an undervalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of $256.84 per share which implies 19.4% upside.
Note that the selected multiple of 29.7x in the analysis above was determined by averaging L3’s current P/E multiple with its peer group.
Understanding the P/E Ratio’s Limitations
Before jumping to the conclusion that L3 should be added to your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to L3, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare L3 with higher growth companies, then its P/E multiple would naturally be lower than its peers since investors reward high growth stocks with a higher price.
source: P/E model
Now if the second assumption does not hold true, L3’s lower multiple may be because firms in our peer group are being overvalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current undervaluation could signal a potential buying opportunity to increase your position in LLL. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on L3 by taking a look at the following:
Valuation Metrics: what is L3’s short ratio and how does it compare to its publicly traded peers? It represents the percentage of total shares outstanding that is being shorted. View the short ratio here.
Risk Metrics: how much interest coverage does L3 have? This is a ratio used to assess a firm’s ability to pay interest expenses based on operating profits (EBIT). View the company’s interest coverage here.
Efficiency Metrics: fixed asset turnover is calculated by dividing revenue by average fixed assets. View L3’s fixed asset turnover here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.