Leidos Holdings Inc (NYSE: LDOS) trades at a P/E multiple of 27.8x, which is lower than the Information Technology sector median of 30.6x. While this makes LDOS appear like a stock to add to your portfolio, 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 Leidos' P/E multiple to those of Booz Allen Hamilton Holding Corporation (NYSE: BAH), CACI International, Inc. (NYSE: CACI), DXC Technology Company (NYSE: DXC) and CSRA Inc. (NYSE: CSRA) in the chart below.
Since Leidos' P/E of 27.8x is higher than the median of its peers (18.7x), it means that investors are paying more than they should for each dollar of LDOS' earnings. As such, our analysis shows that LDOS represents an overvalued stock. In fact, finbox.io's P/E Multiple Model calculates a fair value of $48.57 per share which implies -28.1% downside.
Note that the selected multiple of 20.1x in the analysis above was determined by applying the highest P/E multiple of the company's peer group.
Understanding the P/E Ratio's Limitations
Before jumping to the conclusion that Leidos 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 Leidos, 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 Leidos 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, Leidos' 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 LDOS. 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 Leidos by taking a look at the following:
Valuation Metrics: what is Leidos' 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 is Leidos' financial health? Find out by viewing our financial leverage data metric which plots the dollars in total assets for each dollar of common equity over time.
Efficiency Metrics: is management becoming more or less efficient in creating value for the firm? Find out by analyzing the company's return on invested capital ratio here.
Article by Andy Pai, Finbox.io