EPAM Systems Inc (NYSE:EPAM) trades with a trailing P/E of 44.3x, which is higher than the industry average of 24.4x. While EPAM might seem like a stock to avoid or sell if you own it, 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 EPAM 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 EPAM

Price-Earnings Ratio = Price per share ÷ Earnings per share

EPAM Price-Earnings Ratio = $110.46 ÷ $2.491 = 44.3x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as EPAM, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 44.3x, EPAM’s P/E is higher than its industry peers (24.4x). This implies that investors are overvaluing each dollar of EPAM’s earnings. As such, our analysis shows that EPAM represents an over-priced stock.

A few caveats

However, before you rush out to sell your EPAM shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to EPAM. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with EPAM, 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 EPAM to are fairly valued by the market. If this does not hold, there is a possibility that EPAM’s P/E is lower because our peer group is overvalued by the market.

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.