Although mathematically simple, taking a company’s price and dividing it by its earnings can tell an investor a great deal. The P/E ratio, as it is called, shows how much investors are willing to pay for a dollar of earnings. So, if a company has a stock price of $20 and earnings of $1.00, its P/E would be 20.0. Each dollar of earnings is worth $20 to the market. If that same company, trading at $20 per share, earned $0.50, however, the P/E would be 40—investors would be paying $40.00 for each dollar of earnings.

The price to earnings ratio is a valuation metric, helping to decipher if a stock is expensive or not. Although some use absolute metrics (a P/E over 20 is expensive, for example), P/E is most useful on a relative basis, comparing one company to its historical norms, to another company, or to an industry or market average. It is a way to measure that voting machine mentality of Wall Street about which Benjamin Graham wrote. The thought is that growth and momentum investors are willing to pay more for a dollar of today’s earnings to invest in a quickly growing company. A value investor, meanwhile, would prefer to wait until a company is “on sale” and trading at a low P/E multiple. 

Every week Value Line publishes screens of the highest P/E ratios in the Index section of The Value Line Investment Survey. For this screen, we have chosen to highlight Rackspace Hosting, Inc. (RAX). 

Rackspace Hosting, Inc.

Rackspace was founded in 1998 and is based in San Antonio, Texas. The company offers cloud computing services, and manages web-based IT systems, websites, applications and other needs for its 200,000+ customers worldwide. It has data centers in Dallas, Chicago, Virginia, London, Hong Kong and Sydney, and is actively rolling out cloud capabilities in all of those regions. Its products include customer management portals, as well as cloud servers for computing, storage, and applications (including email, collaboration, file back-ups, and hybrid hosting). Most of its services are sold via direct sales teams, third-party channel partners, and online ordering. The company currently boasts around 100,000 servers and has over 5,000 employees.  Its “hybrid model” supports public clouds, private clouds, and dedicated physical infrastructure.

Once a high flying stock, Rackspace has come down to earth somewhat since mid-February 2013, losing approximately 40% of its value in that time. Obviously, this caused its price-to-earnings multiple to tumble dramatically. In 2011 and 2012 that metric averaged astonishingly high levels of 71.4 and 74.2, respectively, compared to the current 53.3, which is still quite high.

We think one of the primary reasons for the fall from grace has been concerns over increased competition and the “commoditization” of cloud computing. Indeed, the stock experienced some selling following Amazon’s (AMZN) announcement that it would be making price cuts to some of the products offered via Amazon Web Services. We are not overly concerned because the products in question only compete with a small portion of RAX’s business.

In general, we do not completely agree with the viewpoint that cloud computing offerings are becoming commoditized. Differences remain in the core offerings and performance. Further, Rackspace has become adept at talking with customers and custom tailoring architecture to meet their individual needs. We believe Rackspace differentiates itself with its top-notch service and support offerings.

While cloud computing should continue to grow and may cannibalize “managed hosting”, we also think demand for dedicated servers will be vibrant. There is evidence that certain “big data” and legacy applications work better in these environments. Thus, Rackspace’s hybrid offering, OpenStack, should stay in demand for the foreseeable future.

This hybrid approach brings the best of the public, private and dedicated hosting worlds. Public clouds are economical, efficient (because users only pay for what they use), and can easily scale. Private clouds are best for security and reliability, while dedicated hosting space is best for performance. 

The OpenStack platform will help the European CERN laboratory with its ‘‘Openlab’’ project. Other big deals have been inked with Fidelity Investments (FIS) and Mazda North America.

Overall, we think the shares offer a solid risk-and-reward scenario at recent price levels. Although the stock is far from cheap, those willing to take on some risk may be rewarded with price-to-earnings multiple expansion in the coming months. Notably, the company reports earnings on August 8th.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.