Why the P/E Ratio Might Be Useless

Countless investors -- individuals and professionals alike -- spend their time seeking out cheap stocks.

A quick and easy way to find these is by searching for stocks with a low price-to-earnings ratio. This results in a slew of stocks with high P/E ratios being written off as expensive (meaning opportunities often lie hidden in this group).

The problem, though, is that a company with a high P/E ratio may not actually be expensive. A company with a P/E ratio of 50 -- or higher -- may be cheap. Which means...

For some companies, the P/E ratio is meaningless
It's a bold statement, but stick with me.

You see, the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history -- you're purchasing its future cash flows. What matters is what the company is going to do -- not what it has done.

This is important because there are a slew of companies whose P/E ratio may seem high, but their growth potential is so massive that buying them is still a bargain.

But what about the forward P/E ratio?
The forward P/E ratio (a company's market cap divided by its estimated coming-year's profit) may also be meaningless. That's because for many of these same companies, future earnings can't adequately be estimated. Many companies consistently blow short-term expectations out of the water -- so it's a fool's errand to estimate their growth over the long term.

To be fair, for some companies, the P/E ratio might be a telling sign that the stock could be a bargain. But for another category of companies, this metric is one you'd do well to ignore. What kind of companies am I talking about?

High-growth innovative companies that shake up the status quo
An easy example of such a company is Apple (Nasdaq: AAPL  ) . Though its P/E ratio is currently just 16, this wasn't always the case.

In fact, during the first quarter of March 2003, Apple's P/E reached as high as 297. Yet had you bought shares of the company then, you'd be up over 7,300% today!

Apple achieved this remarkable success by continuing to innovate, bringing more and more products to market (the iPod, the iPhone, the iPad) that people didn't even realize they needed.

And although it's a $500 billion company today, its stock could still be a smart buy. If Apple continues to innovate and offer enticing products that consumers eagerly snap up, it could easily become a $1 trillion company -- or larger.

The same is true for Intuitive Surgical (Nasdaq: ISRG  ) . Its P/E ratio ran as high as 299 during the last quarter of 2004. Yet had you bought shares then, you'd be up more than 1,600% today. A $10,000 investment would be worth over $170,000.

Intuitive Surgical came to market with an innovative medical machine that allowed doctors to perform minimally invasive surgeries on patients. It was a win-win proposition: It allowed more precision for the doctor, meant a quicker recovery time for patients, and less risk for both parties.

Its machines were expensive, but it didn't take long for Intuitive Surgical to convince the medical community of the merits of its device. Now it can continue to find new surgical uses for its machine -- or develop ancillary devices within its niche.

And that's why -- even trading for 42 times earnings today -- Intuitive Surgical could still be a smart investment.

These aren't the only companies that have been misjudged
In fact, there's a handful of companies I can think of that similarly fit the bill today.

VMware (NYSE: VMW  ) is a leader in the emerging field of cloud computing. Sales have been growing at a warp-speed compounded annual growth rate of 40% over the past five years. Its P/E ratio is 64.

As cloud computing continues to grow, this early leader will own a dominant share of that market, meaning that even at this price it could still prove to be a bargain years from now.

American Tower (NYSE: AMT  ) owns more than 39,000 cell phone towers throughout the world. Now classified as a REIT, it leases out space on its towers to cell phone network providers. Its P/E ratio is currently 64.

But as cell phones, tablets, and countless other devices continue to grow in prominence, bandwidth becomes more and more crucial -- meaning cell phone network providers will have to make their networks even stronger to handle the additional traffic. All of this is why American Tower's stock should be a bargain today.

Lastly, Amazon.com (Nasdaq: AMZN  ) , the world's largest online retailer, has a P/E ratio of 134. On the face of it, this seems insanely high for a company with a market cap of more than $80 billion. Yet Amazon is furiously building out its empire -- both through acquisitions like Zappos and Diapers.com and through expanding its platform with devices like the Kindle. Not to mention, it also has a growing presence in the cloud computing niche, leasing out server space and offering virtual storage.

I think it's safe to say that the Amazon of the future will be vastly different than the Amazon of today -- and investors who get in today (even with its high P/E ratio) will be glad they bought shares when they did.

These aren't the only high-P/E stocks that would be smart to buy today
Motley Fool co-founder David Gardner has built his investing career largely around buying "overvalued" high-P/E stocks (including those I shared above) -- and with much success. In fact, his lifetime annualized return is a remarkable 19.6%, versus just 8.1% for the S&P 500.

David's about to launch a new venture called Supernova, in which he will share real-time buy and sell recommendations based upon his stoc ks -- so investors can mirror the trades in his real-money portfolio. To find out more about this exciting launch, simply type your email address in the box below. We'll tell you more about Supernova, and put you on the private invitation list for when we open its doors.

Adam J. Wiederman owns no shares of the companies mentioned above. The Motley Fool owns shares of Amazon.com and Apple. Motley Fool newsletter services have recommended buying shares of American Tower, Apple, Amazon.com, VMware, and Intuitive Surgical. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (28)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 16, 2012, at 3:36 PM, bear9 wrote:

    The reason not to pay attention to PE ratios on REITs like AMT has nothing to do with the growth. It has everything to do with accounting. GAAP earnings for REITs is badly distorted by the tax consequences of depreciation. The appropriate metric is cash flow (or, in REIT terms, Funds from Operations). For the life of me, it seems none of the MF commenters get this point. There are other valid metrics than PE. And PE is completely inappropriate for REITs.

  • Report this Comment On March 16, 2012, at 11:40 PM, Clint35 wrote:

    Adam I don't know how old you are? Are you too young to remember the .com bust? Well, before the bust happened there were a lot of people saying that value investing was dead and the P/E no longer mattered. After the bust the P/E suddenly mattered again. I agree that it shouldn't be the only metric investors look at and we shouldn't be afraid to pay up for companies that might have astonishing growth ahead of them. I'm even a Rule Breaker subscriber and I love and admire a lot of those companies. But to say the P/E doesn't matter is going too far. But, good article.

  • Report this Comment On March 17, 2012, at 12:37 PM, KMAFool wrote:

    The key term here SOME companies. For these type high growth stcoks, the PE may not be a good guide. For more mature slower growth companies, it can be more helpful. But even mature cyclical stocks, the PE can be misleading - case in point are auto stocks. In years past as they went through their ups and downs, you had to sell with both hands when their PE were low single digits and buy when they were sky high due to low (or no) earnings.

  • Report this Comment On March 17, 2012, at 1:23 PM, ScottRichard wrote:

    Your point on the weakness of the P/E is well taken. However, the weakness of any single metric deserves recognition. P/E is but one measure that needs to be considered along with Price/Growth PEG, Cash Flow, ROE, etc. The use of any single metric is foolish with a small "f". Instead, capitalize on good analysis and Fool on!

  • Report this Comment On March 17, 2012, at 2:33 PM, miclombardo wrote:

    "Those who emphasize prediction will endeavor to anticipate fairly accurately just what the company will accomplish in future years—in particular whether earnings will show pronounced and persistent growth. [...]

    If [those who emphasize prediction] are convinced that the fairly long-term prospects are unusually favorable, they will almost always recommend the stock for purchase without paying too much regard to the level at which it is selling. Such, for example, was the general attitude with respect to the air-transport stocks [...]

    By contrast, those who emphasize protection are always especially concerned with the price of the issue at the time of study.

    Their main effort is to assure themselves of a substantial margin of indicated present value above the market price—which margin

    could absorb unfavorable developments in the future.

    The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and

    other nonmeasurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called the quantitative or statistical approach, since it

    emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth. [...]

    Thus this matter of choosing the “best” stocks is at bottom a highly controversial one."

    Benjamin Graham, The Intelligent Investor, Ch. 14.

  • Report this Comment On March 17, 2012, at 2:35 PM, pky562 wrote:

    Good point, but I have a comment with one statement you made, " so it's a fool's errand to estimate their growth over the long term."

    My problem is the entire point of this article is you should buy stocks whose P/E or Forward P/E who's growth allows the intrinsic value to be higher than the valuation that causes High P/E's. How does one determine this? Buy doing exactly what you said is a fool's errand. Now I don't think anyone can do it that accurately, so I agree with you that it is hard. But if you're going to buy High P/E stocks you better at least hope you estimated their high growth accurately.

  • Report this Comment On March 17, 2012, at 2:41 PM, oberta wrote:

    P/E is not enough! It can help, but there are more indications required such as the ROE (return on equity>15%, debth to equity <0,5, the current assets/current liabilities > 1,5

    Above a good report, it gives us thinking on the other side of the medal.

  • Report this Comment On March 17, 2012, at 4:17 PM, Synchronism wrote:

    Adam, I agree with you on one point in your article. And one point alone: that the P/E ratio can be meaningless for some companies.

    On the low end of the sliding scale, you have what could be a value trap. On the opposite end, you have a potential false negative in your hands.

    However, your article doesn't substantially explain why the "false negative" exists.

    All you wrote about is how "it's a retroactive metric" that "pits...current market cap against... TTM profit", and that the forward P/E ratio is meaningless.

    Now... both are true. Yet, your article is lacking.

    I find it sad that your work still has to be elucidated by the users. Even more so when my comment -- along with the others above (and perhaps, below) me -- will undoubtedly have more value than your article.

    You completely missed the point that prohibitively high P/E ratios could be caused by, aside from irrational exuberance, abnormally low earnings for a given year, caused by one-time events -- may they be unusual items in the expense account or an unsustainable but unexpected drop in sales.

    Benjamin Graham has actually suggested employing a P/E ratio with "E" being the average. James Montier has developed this idea further by propounding usage of an estimate of "sustainable" earnings as the denominator.

    You can also complement P/E with other screening ratios... like P/B. Why? "Book Value" doesn't change as fast as "Net Earnings", so if you find a very high P/E ratio and a rather low one (I define low as below 2x book value), instead of writing it off as an unreasonably overvalued stock, you investigate just a little bit further.

    Now, a point I would disagree with is that sentence of yours about the "Forward P/E".

    As much as I'd like to concur with you and agree that estimating LT growth over the long run is a fool's errand, you've said it yourself -- equity investors buy shares FOR ITS FUTURE PERFORMANCE.

    Any fool (no pun intended, srsly) can figure out price is a function of subjective expectations and actual business results. Studies by Societe Generale has revealed that 80% of returns over the long term (and by long-term, I mean 5 years and up) comes from both the prosperity of the underlying business and the price you paid for it; whereas, in the short run, 60% comes from changes in valuations -- in price fluctuations resulting from both short-term expectations and macroscopic fluctuations in the market.

    Future growth is therefore important. Why it is "a fool's errand" is highlighted by the fact no one can consistently predict the future. Consequently, you compensate for this in three ways: (a) you employ scenario analysis; (b) you evaluate zero growth to determine how much "mark-up" is embedded in the market price; and (c) you compare market expectations to either historical performance or your knowledge on the company's competitive advantages and the engines driving the industry.

    Still, despite your incomplete points, I'd like to thank you for giving me ideas -- VMware seems like something good to look at if its position in cloud computing doesn't grant it an absurdly high innate P/E, and American Tower points out that "intangible real estate" (i.e. bandwidth or virtual storage) can be something worth looking into.

    Yours,

    Synchronism

  • Report this Comment On March 17, 2012, at 5:50 PM, optimist911 wrote:

    This is sort of like claiming that a college education is useless because Bill Gates and Steve Jobs both dropped out, yet went on to build multibillion-dollar companies.

  • Report this Comment On March 18, 2012, at 3:08 PM, Sorval wrote:

    As others say P/E needs support from other measures. However, I must admit that I would never buy any company with a P/E ratio >15 (prefer <10) unless I had inside information (which would be illegal). These companies with excessive P/Es are like musical chairs when the market turns. Somebodies going to be left without a seat. I'd make the same argument for gold and silver. That being said a low P/E can leave you stuck in value traps. Given the two negative scenarios, I'd rather be in a value trap than stuck with a falling knife.

  • Report this Comment On March 18, 2012, at 9:18 PM, tamalesis wrote:

    P/E helps determine if a stock is value or growth. When the market runs, it runs with growth but when it drops, investors ride out with value.

  • Report this Comment On March 19, 2012, at 11:41 AM, KMAFool wrote:

    Synchronism

    Great note on James Montier. I was not familiar with his work on sustainable earnings. Interesting concept I will review in more detail. Thanks for the post.

    KMA

  • Report this Comment On March 19, 2012, at 5:23 PM, mikecart1 wrote:

    I never paid attention to P/E ratios. The key is buying stocks that others believe should be higher in share price. That is the only thing that matters. Throw the charts, past performance, key indicators. analyst estimates, revenue, ratios, patterns, and everything else that isn't the share price out the window. In 2012, the only thing that matters is whether everyone thinks a stock price is overvalued or undervalued.

    :)

  • Report this Comment On March 19, 2012, at 11:44 PM, gaspeddler wrote:

    A REIT like Annaly (NLY) has a P/E of 44, sits on

    tons of money, and distributes most of its income

    to investors. Is bear9 right; is the high P/E a

    bookkeeping ruse or something else?

  • Report this Comment On March 21, 2012, at 1:44 AM, drstocks1 wrote:

    isrg is great story. enter new competition with even better equipment just approved to be studied at columbia university. stock is at $1.70 and will compete for expanding market now at one billion and soon to be $5 billion. stock symbol TITXF

  • Report this Comment On March 05, 2013, at 12:38 AM, mJuliep wrote:

    I think that P/E is a good tool for novice investors. Perhaps the veteran investor can seek other methods of evaluation, but this P/E a great place to start. I actually recently found a useful video that clearly explained how and why P/E is used: http://blog.sprinklebit.com/video-how-to-analyze-a-company-u...

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