Is Palo Alto Networks 4 Digit PE Justified?

Key Points

• It's one of the few growth stocks with a 4-digit PE. 
• Shares are still up 50% since January. 
• Last night's earnings point towards further gains in the near term.

There are few stocks out there with a 4-digit price-to-earnings (PE) ratio still showing gains for the year, but Palo Alto Networks Inc NASDAQ: PANW is one of them. What's all the more surprising is that this isn't even part of a recovery bounce. No, instead it's a case of Palo Alto shares trading right up near their all-time highs and nearly 50% higher from where they started the year. 

This will be such a surprise to many of our readers because the days of 4 and even 3-digit PE ratios had, for the most part, been consigned to history once the Fed started raising rates to cool inflation.

Growth Stock Headwinds 

For context on this, a high (and especially a very high) PE ratio suggests that the market is putting a huge amount of faith in a company's ability to justify its current share price with strong future earnings. In other words, it's a growth stock. A growth stock's ability to deliver on this future performance can be significantly dampened when rates are raised, as their costs increase and profitability margins are tightened. So for Palo Alto shares to be thriving in the manner they are while commanding a PE ratio of 2,400 means they are one of the few growth stocks still being treated as a darling of Wall Street. 

Compare that PE to Amazon Inc's NASDAQ: AMZN, for example, which is 'only' 280, or Tesla Inc's NASDAQ: TSLA 55. Both tech titans were infamous for their gargantuan PE ratios in the past. However, both have seen their PE ratios fall back towards earth through a combination of their earnings increasing and their share prices being cut to 40% and 55%, respectively. 

Regarding Palo Alto, investors are still betting heavily that growth in the company's future earnings will be the major factor in its PE ratio also maturing in the future. Because it certainly doesn't look like its stock will be cut in half anytime soon. Last night the cybersecurity company released its fiscal Q3 numbers, which only reinforced this train of thought. Revenue was in line with expectations and up an impressive 24% year on year, while EPS easily beat the consensus, coming in almost 20% higher. 

Strong Outlook

It was a record quarter in terms of revenue generated, while also the fourth quarter in a row of a positive net income. Given the PE ratio the stock has been commanding, any sign of slippage in either of these metrics could have been disastrous for the stock. Instead, it popped 5% in Tuesday's after-hours session and was holding onto those gains in Wednesday's pre-market trading. Beyond the decent headline numbers, investors were also impressed with management's forward guidance. 

CFO Dipak Golechha summed this up, saying that "we continued to demonstrate our commitment to profitable growth in Q3. As a result, we are raising our cash flow margin and operating margin guidance for FY'23 as we balance driving efficiency goals while investing for medium-term growth." This would have been music to the bulls' ears because, again, any sign of decelerating growth on any of the key metrics would have weighed heavily on the stock. 

Getting Involved 

For investors considering getting involved, there are some interesting questions to tackle. Given how strong the stock has performed in the face of the macro headwinds, is it fair to think it's conclusively shrugged off the risk of being dragged down 30-60% simply for being a growth stock? Or is Palo Alto balancing more delicately than ever on the tightrope of fundamental results in the face of a rising interest rate environment that's just waiting to take shares back down to earth? 

For now, it looks like the former is the case. Remember that the stock did drop the guts of 40% from April of last year through January, so that could be considered an effect of the tightening rate environment. But there's no denying how well it's performed in 2023 so far, and it feels like this isn't a stock to be fighting the trend on.