DigitalOcean's price surge today seems to be confirming the bullish analyst outlook on the stock. Ending the day at $36.71, DOCN has posted 9.5% gains, pushing the valuation of the stock even higher. Might the stock be overvalued, despite its buy rating?
The most common valuation metric for stocks is the trailing price to earnings (P/E) ratio. DigitalOcean has a P/E ratio of -115.1 based on its 12 month trailing earnings per share of $-0.32. Considering its future earnings estimates of $1.23 per share, the stock's forward P/E ratio is 29.8. In comparison, the average P/E ratio of the Technology sector is 26.5 and the average P/E ratio of the S&P 500 is 15.97.
DigitalOcean's P/E ratio tells us how much investors are willing to pay for each dollar of the company's earnings. The problem with this metric is that it doesn't take into account the expected growth in earnings of the stock. Sometimes elevated P/E ratios can be justified by equally elevated growth expectations.
We can solve this inconsistency by dividing the company's trailing P/E ratio by its five year earnings growth estimate, which in this case gives us a 0.58 Price to Earnings Growth (PEG) ratio. In DOCN's case, the elevated P/E ratio is justified by future earnings growth estimates -- assuming those estimates turn out to be close to reality.
We can also compare the ratio of DigitalOcean's market price to its book value, which gives us the price to book, or P/B ratio. A company's book value refers to its present liquidation value -- or what would be left if the company sold off all its assets and paid off all of its debts today. Importantly, the book value does not include intangible assets such as the value of its brand and the goodwill of its customers. DOCN has a P/B ratio of 73.7, with any figure close to or below one indicating a potentially undervalued company.
A comparison of the share price versus company earnings and book value should be balanced by an analysis of the company's ability to pay its liabilities. One popular metric is the Quick Ratio, or Acid Test, which is the company's current assets minus its inventory and prepaid expenses divided by its current liabilities. DigitalOcean's quick ratio is 16.304. Generally speaking, a quick ratio above 1 signifies that the company is able to meet its liabilities.
Next up in our analysis is DigitalOcean's levered free cash flow, which stands at $36042000.0. This represents the cash that is available to the company after all of its expenses and income are accounted for -- including those that arise outside of its core business activities. This money can be used to re-invest in the business or to payout a dividend. For now, at least, DigitalOcean has chosen the former.
By most metrics, DigitalOcean is an overvalued stock. So why are analysts giving it such a generous rating? It probably has to do with their perception of its strong growth potential, as represented by low PEG ratio. For growth-oriented investors, DOCN is represents an interesting opportunity despite its elevated valuation. They just need to be sure that the growth story will come true. We will continue to monitor the stock to see which thesis prevails. Don't want to miss our next analysis? Make sure to subscribe to our free daily newsletter!