Why Is the Market Punishing Ambarella Inc?

Earlier this summer, shares of video chip maker Ambarella (AMBA -1.72%) were riding high. Share prices peaked well over $120, more than double where they were at the outset of 2015, and the growth outlook for the company looked unstoppable. Since then, shares have taken a dramatic turn for the worse and are down about 50%.

As investors assess the situation, they are bound to question the company's future growth prospects and whether the market's brutal treatment of the company is warranted.

Why the last three months have been so brutal...
Back in June of this year, Ambarella stock briefly touched over $128 a share. By the end of June, though, Ambarella had come under fire by Citron Research, stating that the company was highly overvalued and calling for 12- and 18-month price targets of $60 and $40, respectively. In a previous Motley Fool article, I outlined how a high-growth company like Ambarella has future growth expectations already priced into current share valuations, and one way investors can assess the value of such a company. Despite an initial tumble, the stock proved resilient and rebounded. What happened next is significant for investors to keep in mind when evaluating a potential long-term investment.

Mainly driven by a forecasted slowdown in sales of wearable cameras in the company's second-quarter 2016 earnings conference call, many investors started selling off Ambarella stock as future earnings growth potential came into question. Now that the market has sent shares back to valuations a la spring of 2015, it's time to reassess the company's growth profile and valuation going forward.

Can future growth push prices higher?
Let's take a look at the most recent financial reports for Ambarella along with upcoming expectations:

Data source: Yahoo! Finance.

An important takeaway from these numbers is earnings growth. Expectations are that earnings grow over 30% by the end of the current fiscal year, and another 15% by the end of the fiscal year ending in January 2017. Those are lofty growth numbers if they are realized, but Ambarella has a track record of exceeding those expectations. Five-year earnings growth has been averaging over 25%.

As I mentioned earlier, those earnings expectations are cooked into current share prices, as indicated by the relatively high trailing and forward P/E ratios. The question now is whether or not it's fair to pay for those future growth expectations. We can analyze that by comparing the company's PEG ratio (or the forward P/E divided by earnings growth expectations) to those of Ambarella's competitors -- namely Qualcomm (NASDAQ: QCOM), Intel (NASDAQ: INTC) and Texas Instruments (NASDAQ: TXN). 

Data source: Yahoo! Finance.

When using the forward price to earnings number, Ambarella does appear to be overpriced compared to key competitors, but it becomes a different story entirely when looking at future earnings estimates and PEG ratio. Ambarella appears to be a value when factoring in the growth analysts expect to see. This is a new development over the last month, as the market has reacted negatively to Ambarella's last quarterly earnings, and concerns over competition have cropped up (although CEO Fermi Wang stated on the last earnings conference call that the competitive landscape has not significantly changed for the company).

Takeaways for investors
Although it has been a brutal month for Ambarella investors, it appears the market has overreacted a bit. When looking at growth expectations for the business relative to its competitors, Ambarella looks like it could significantly outperform the industry over the coming years. The recent pullback in price could be a nice opportunity for investors who have been eyeing Ambarella to add a long-term position, or for current investors to buy more.