Is Ambarella a Good Value?

Ambarella (AMBA -2.79%) has had a wild ride this summer. The semiconductor company best known for its relationship with GoPro, which uses Ambarella to power its digital cameras, has seen wild changes in its stock price.

Ambarella got off to a solid start in 2015 with strong quarterly results, showing double-digit earnings growth from last year. This caused the share price to more than double through June. Since then, prices have been gyrating up and down, ranging from over $129 to under $95 in June and July.

As with other stocks that post high returns over a short period, the question regarding fair value and future value arises. Is the company currently overpriced? Will the stock continue to run higher? If so, what will cause it to go higher? Is current growth sustainable for the long term? Let's take a look at these questions for Ambarella.

Ambarella A7LW-Wearable Camera. Source: Ambarella.

What is the value of Ambarella stock right now?
Let me first set some proper expectations. I won't give an exact number on what I think the current stock price should be. It's difficult to assess the current value of a company that's in a strong growth stage, because the share price reflects the expected growth of future earnings.

We can glean quite a bit, though, from looking at the financial ratios and comparing them with the company's peers. Here's a summary look at some key statistics:

Source: finviz.com.

One of the leading concerns for Ambarella's stock is the high valuation using both trailing price-to-earnings and estimated forward price-to-earnings ratios. In simple terms, the P/E ratio measures how many years of earnings it will take to recoup the value of one share.

Why would one be willing to pay over 57 years of trailing-12-month earnings for one share of this company? The answer is in the estimate of earnings growth. If the company were to be successful in generating 20% annual earnings growth for the next five years, earnings would balloon from last year's $1.96 in annual EPS to $4.88 at the end of five years.

It's worth noting, however, that competitors operating in the same space have average trailing and forward P/E ratios of 35.0 and 15.9, respectively. Is it worth paying a premium for Ambarella? One way to answer that question is by using the P/E-to-earnings growth ratio, or PEG, which measures a company's value compared to expected earnings growth over a specified period: typically five years. 

Using the current P/E of 57.80 and estimated growth rate of 20% yields a PEG ratio of 2.89. The industry Ambarella operates in has an average five-year earnings growth rate of 15.7%. Dividing the industry P/E of 35.0 by 15.7 gives us an average PEG ratio of 2.23, implying that Ambarella is indeed trading at a hefty premium when compared to competitors' estimated growth.

To bring Ambarella's PEG into line with the industry's would require a forward growth rate of about 28% per year for the next five years, substantially higher than the estimate.

To be fair, analysts are expecting 50% year-over-year earnings growth this year, a number that could make beating 20% annualized growth over the next five years more attainable. By my estimation, however, the share price has currently outpaced realistic future profit growth, and any purchase at current prices would be at a premium to fair value. A future test of this claim will come early next month, when Ambarella releases its next quarterly results.

What the future may hold
All that said, Ambarella does have a strong tailwind driving the business forward. Its HD and Ultra-HD video chips have found their way into a myriad of products, ranging from drones to action cameras and other wearable tech devices.

Despite my opinion that the current stock price looks expensive, I do expect that underlying fundamentals will bode well for the company, and business expansion seems likely. Over time, increasing sales and profitability could prop up the share price. But how long can the company sustain its current run of 26% earnings growth?

I would keep a pulse on the expansion of both drone technology (and the attendant consumer, commercial, and government demand for such products equipped with video-capturing technology) and wearable devices and other tech gadgets that include the ability to take high-definition videos. The continuing proliferation of such gadgets will ultimately be the primary driver of Ambarella's continuing success.