Cognizant Technology Solutions Corp (NASDAQ: CTSH) trades at a P/E multiple of 31.5x, which is higher than the Information Technology sector median of 29.3x. While this makes CTSH 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 Cognizant’s P/E multiple to those of DXC Technology Company (NYSE: DXC), Leidos Holdings, Inc. (NYSE: LDOS), Booz Allen Hamilton Holding Corporation (NYSE: BAH) and Infosys Limited (NYSE: INFY) in the chart below.
Since Cognizant’s P/E of 31.5x is higher than the median of its peers (19.7x), it means that investors are paying more than they should for each dollar of CTSH’s earnings. As such, our analysis shows that CTSH represents an overvalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of roughly $59.00 per share which implies approximately 28.0% downside.
Note that the selected multiple of 22.8x in the analysis above was determined by averaging Cognizant’s current P/E multiple with its peer group.
Understanding the P/E Ratio’s Limitations
Before jumping to the conclusion that Cognizant should be banished from 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 Cognizant, 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 Cognizant with lower growth companies, then its P/E multiple would naturally be higher 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, Cognizant’s higher multiple may be because firms in our peer group are being undervalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to CTSH. 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 Cognizant by taking a look at the following:
Valuation Metrics: what is Cognizant’s price to book ratio and how does it compare to its peers? Analyze Price / Book here.
Risk Metrics: what is Cognizant’s CapEx coverage? This is the amount a company outlays for capital assets for each dollar it generates from those investments. View the company’s CapEx coverage here.
Efficiency Metrics: inventory turnover is a ratio that measures the number of times a company’s inventory is sold and replaced over the year. View Cognizant’s inventory 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.