I am sure you have heard about the P/E ratio. Although not without its flaws, it’s probably the most commonly used ratio when looking to see if a stock is overvalued or undervalued.
Investors often refer to stocks as high or low P/E stocks, but in this article we’ll mainly look at high P/E ratios, specifically:
- What does a high P/E ratio mean?
- Why does a stock have a high P/E ratio?
- Should you buy a stock with a high P/E ratio?
- The risks of buying high P/E stocks
Chances are you have noticed that the P/E ratio varies greatly from stock to stock, anywhere from reaching deep down into the negative, up to a couple of hundreds even.
So what do these numbers mean?
What does a High P/E ratio mean?
First of all, to get the P/E ratio you take the share price and divide it by the EPS (Earnings Per Share.) So a company with a share price of $30 and an EPS of $3, would have a P/E ratio of 10.
Now imagine a company with a share price of $90 and again, an EPS of $3, resulting in a P/E ratio of 30.
Both companies have an EPS of $3, the difference is the share price. As you can see in the example, a high share price relative to earnings results in a high P/E ratio.
For a stock with a P/E ratio of 10, you pay $10 for $1 of the company’s earnings. With a ratio of 30, you pay $30 for $1 of earnings.
Simply stated, a high P/E ratio means that the stock is expensive and a low ratio means that it is cheap.
But you shouldn’t make the common mistake of automatically assuming an expensive stock is overvalued or a cheap one is undervalued. Whether or not a stock is undervalued or overvalued depends on a myriad of things, some of which we will look at later.
Now that we understand that a high P/E ratio means that you’re paying relatively much for a company’s current earnings, let’s look at why some stocks have such a high P/E ratio.
Why do some Stocks have High P/E Ratios?
As previously stated, a high P/E ratio is the result of a high share price relative to the company’s earnings, but why are investors willing to pay these hefty prices for a stock?
The reason is quite simple. Investors paying high prices for a stock expects the company to grow its profits in the future, at a pace that makes it worth it for them to pay an overprice for the company’s current earnings.
In other words, they are not paying high prices for the current earnings. They are paying high prices for the expected much higher future earnings.
A good example of this is Netflix. In 2016 the stock traded at a P/E ratio of around 300, which is very, very high. But from 2016 to 2020 the annual EPS skyrocketed from $0.43 to $6.08, a 1,300% increase. And the share price increased by around 450%.
Amazon was pretty much the same. In 2016 the stock traded at a P/E ratio of around 200. And from 2016 to 2020 the EPS increased from $4.9 to $41.83, a 750% increase while the share price increased around 460%.
These were just two examples of high P/E stocks with extremely favorable outcomes. If you were to look, you would probably find surprisingly many cases where high P/E stocks never reached their expected earnings and in turn, came crashing down.
I would like to give some examples from the dot com bubble but since most of those companies didn’t even have any earnings, they couldn’t have high P/E ratios. But high P/E ratios or not, most of the tech companies during the time were ridiculously expensive.
Cisco was trading at a P/E ratio of over 200 during the bubble, in the subsequent years, the share price dropped 90%.
Should you buy High P/E Stocks?
Whether or not you should buy a stock with a high P/E ratio is situational. As you could see in the examples above, there have been times when paying a high price for a stock turned out to be worth it.
But I can almost assure you there have been as many if not more times when paying a high price for a stock turned out to be a mistake.
So buying a high P/E stock is essentially betting on the company’s probability of increasing its profits. And like with all things, there are good and bad bets.
To increase your odds, it’s very important to do your research before investing in anything, but especially before investing in expensive stocks. Always conduct a fundamental analysis and if you don’t know how to do one, here is an article explaining it.
A fundamental analysis basically consists of two parts: quantitative and qualitative analysis. Quantitative analysis involves looking at the numerical data, i.e., the data in the income statement, balance sheet, and cash flow statement. Qualitative analysis means analyzing the data not talked about in numbers, e.g., the business model, management, competitive edge.
After the fundamental analysis, you’re better equipped to decide on whether or not you should invest.
Another important thing when investing in high P/E stocks is to know about the risks.
The Risks of Investing in High P/E Stocks
When buying high P/E stocks, you’re paying a high price for expected growth. And expectations always run the risk of not coming to pass. What do you think happens when you pay a high price for something that then doesn’t occur?
I’m going to tell you what happens: the price most likely crashes. Here’s another question: What do you think happens when something that is already expected and priced in, occurs?
In many cases, not much.
In his book, Contrarian Investment Strategies: The Psychological Edge, David Dreman compared the effect of earnings surprises had on high and low P/E ratio stocks. You can read about it in this article.
But let me give you the quick version:
Positive earnings surprises had a much smaller positive impact on the price of high P/E stocks than they did on low P/E stocks.
And at the same time, a negative earnings surprise affected the prices of high P/E stocks much worse than it did a low P/E stock.
The reason for this is expectations. When high P/E stocks perform well, it is what the investors expected. When they perform badly, though, it’s not expected and not what the investors paid hefty prices for.
On the other hand, bad performance is expected of low P/E stocks. So when they perform badly, it was expected. And when they perform well, everyone is pleasantly surprised.
A high P/E ratio means that the stock is expensive in relation to its earnings. When you buy a high P/E stock you pay more for a dollar of earnings than you do with a low P/E stock.
The high price may or may not be justified by the probability that the company will increase its profits in the future and by how much.
Whether or not you should buy a high P/E stock largely depends on how high this probability is as well as how much they can hope to grow the profits.
To increase the likelihood of making a good investment you should always conduct a fundamental analysis before investing. A fundamental analysis consists of analyzing the income statement, balance sheet, and cash flow statement. But also the business model, management, and competitive edge.
The risk of buying high P/E stocks is the fact that you’re often paying for the promise of future growth. This promise may or may not come to pass and if it doesn’t, the price will most likely suffer as a consequence. With high expectations comes great risk.