Yahoo Finance Does Cadence Design Systems Inc’s (NASDAQ:CDNS) PE Ratio Signal A Selling Opportunity?
This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Cadence Design Systems Inc (NASDAQ:CDNS) is trading with a trailing P/E of 59.7, which is higher than the industry average of 51.2. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Check out our latest analysis for Cadence Design Systems
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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.
P/E Calculation for CDNS
Price-Earnings Ratio = Price per share ÷ Earnings per share
CDNS Price-Earnings Ratio = $46.91 ÷ $0.785 = 59.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to CDNS, 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 CDNS’s P/E of 59.7 is higher than its industry peers (51.2), it means that investors are paying more for each dollar of CDNS’s earnings. This multiple is a median of profitable companies of 25 Software companies in US including ZIM, Alfa Financial Software Holdings and Avaya Holdings. You could also say that the market is suggesting that CDNS is a stronger business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to CDNS. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Cadence Design Systems Inc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to CDNS may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
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 rebalance your portfolio and reduce your holdings in CDNS. 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 CDNS’s future growth? Take a look at our free research report of analyst consensus for CDNS’s outlook.
Past Track Record: Has CDNS 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 CDNS’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.
To help readers see past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
