When to Ignore P/E

There's no metric investors turn to more often than a company's price-to-earnings ratio. Most of the time, it lets investors know whether they are paying too much or getting a deal on a stock. For many investors, anything with a P/E of more than 30 is too pricey.

Sometimes, however, the steadfast reliance on P/E can eliminate some of the greatest companies from one's retirement portfolio. Below, I'll give you three different instances in which you'd be better off ignoring the P/E ratio, and at the end, I'll offer a special free report on three companies that will help you retire rich.

Earnings are just getting started
For companies that have just swung from operating in the red to turning a profit, earnings per share are often minuscule. This sets up a situation where no matter what the price of a stock is, it looks wildly overvalued. Usually, looking at what earnings are predicted to look like in a year or two can be more informative.

Universal Display (Nasdaq: PANL  ) makes devices with organic light emitting diodes. In plain language, it makes and holds patents on the lights used in flat-screen TVs, smartphones, and a host of other products. Because OLEDs generally require less energy than other forms of lighting, the runway for growth is extensive.

Obviously, a company with such potential demands a high price, but with earnings per share of just $0.30 over the past 12 months, the company has a P/E of around 120. Though that looks ridiculous now, S&P Capital IQ estimates peg the company's earnings at $2.38 per share by 2014, which means it's trading at a much lower multiple of about 15 times its estimated 2014 earnings.

Much the same is the case with LinkedIn (NYSE: LNKD  ) , the professional-social-networking site. Contrary to what some may believe, the company has three steady streams of revenue growing quickly. In fact, the company just released figures showing revenue grew by 101% last quarter.

With trailing-12-month earnings per share of just $0.15, the company's P/E currently sits above 750. As earnings grow, this number will undoubtedly sink.

Mr. Market's showing some respect
Another reason that shares may be bid to the point where a company looks expensive is because it's highly respected. Investors are willing to pay a premium for high-quality companies growing at a fast clip. By avoiding companies with high P/Es, you may very well be throwing away a chance at owning our generation's greatest companies.

Baidu (Nasdaq: BIDU  ) , for example, trades at 36 times earnings, which looks a little pricey. But as fellow Fool Rick Munarriz points out, there's no doubting the growth of this Chinese search giant. The company has grown earnings by an astounding 80% per year over the last five years, as more and more Chinese citizens come online.

Another clear example of a stock highly respected by the market is 3D Systems (NYSE: DDD  ) , which sports a P/E over 40. The company is on the cutting edge of 3-D printing, a technology that promises to change our world the same way the personal computer did in the 1980s and 1990s. Our top analysts at the Fool have already tapped the company as one that can "take manufacturing to a new level." Earnings grew 81% in 2011 versus 2010, and analysts expect EPS to nearly double next year compared to their 2011 levels.

Building an impenetrable moat
The final reason some companies have a high P/E is that they are spending money to build a sustainable competitive advantage. Such is the case with Amazon.com (Nasdaq: AMZN  ) .

Amazon is building out its array of fulfillment centers across America right now. That costs the company billions of dollars. But those investments not only allow the company to deliver to customers in the blink of an eye, they build a huge moat around Amazon.

In order for any company to come close to offering the same service to customers as Amazon does, a competitor would have to be hugely unprofitable for a long time to match Amazon's scale. And consider this: Once the build-out of centers decelerates, there will be far more revenue dropping to the bottom line than there's ever been before.

AMZN Revenues TTM Chart

AMZN Revenues TTM data by YCharts

What's a Fool to do?
Let's be clear: I'm not saying that any of these companies are necessarily cheap, or the best deals on the market. What I am saying is that sometimes, the P/E metric can be misleading. Whether it's because the company is just becoming profitable, is highly respected by the market, or is simply building an impenetrable moat, there are lots of good reasons to buy into high-P/E companies.

As I said at the beginning, you want to make sure your retirement portfolio has the best of the best companies included. We've prepared a special free report to help you: "3 Stocks That Will Help You Retire Rich." One of those three companies is actually mentioned in this article. To find out which one it is, get your copy of the report today, absolutely free!

Fool contributor Brian Stoffel owns shares of Amazon.com, LinkedIn, and Baidu. You can follow him on Twitter, where he goes by TMFStoffel.

The Motley Fool owns shares of all of the companies mentioned in this article and has written calls on 3D Systems. Motley Fool newsletter services have recommended buying shares of all of the companies mentioned in this article. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (16) | Recommend This Article (38)

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 May 11, 2012, at 5:04 PM, Mega wrote:

    "Though that looks ridiculous now, S&P Capital IQ estimates peg [PANL's] earnings at $2.38 per share by 2014, which means it's trading at a much lower multiple of about 15 times its estimated 2014 earnings."

    Well, have fun paying 15 times (over)estimated 2014 earnings. Since their major patents start expiring in 2018, I expect earnings to be back down to 0 by 2020.

  • Report this Comment On May 11, 2012, at 7:46 PM, mrudolph72 wrote:

    Ask those that invested in 2000 while ignoring PE ratios how well it worked out. I'm disappointed The Fool would post this rubbish,

  • Report this Comment On May 11, 2012, at 10:30 PM, goalie37 wrote:

    The article only succeeds with making half a point. If the writer suggests we sometimes look past the P/E, what other metrics would he have us look at? You can't throw all valuation out the window just because a company is growing quickly. Every stock has a price at which it is fairly valued, and therefore every stock has a point where it is too expensive to buy. Otherwise we are just back to where we were in the dot com bubble.

  • Report this Comment On May 12, 2012, at 9:11 AM, TMFCheesehead wrote:

    @mrudolph-

    As I stated at the end, <<Let's be clear: I'm not saying that any of these companies are necessarily cheap, or the best deals on the market. What I am saying is that sometimes, the P/E metric can be misleading.>>

    Brian Stoffel

  • Report this Comment On May 12, 2012, at 12:28 PM, wrenchbender57 wrote:

    Actually Brian does give the readers another method although that is not crystal clear in this article. That is the forward PE ratios. He implies that method several times in the article. Not that hard to pick it out. A few other methods would also have been appreciated. But, I would guess these articles need to be limited in length.

  • Report this Comment On May 12, 2012, at 12:50 PM, smsmyer wrote:

    P/E is only one metric. I own both Verizon & AT&T which both have P/E's over 40, and I'm comfortable adding to my positions.

  • Report this Comment On May 12, 2012, at 2:05 PM, lrob05055 wrote:

    The Amazon argument might have merit at 40 or 50 times earnings. At 180+ times earnings it's just the greater fool argument. This company has as many negatives as positives. It will probably do poorly sometime in the next six months. I'm short the stock even though I love the company. In this case the outlandish PE is telling people loud and clear to stay away.

  • Report this Comment On May 12, 2012, at 3:12 PM, aptosjoe wrote:

    I think the point is that using a single metric to evaluate a company is often misleading. What would be more interesting is how to weigh multiple metrics. Or perhaps to discuss which metrics are more pertinent when applied to a company's developement stage. I think it is obvious that a mature company will have a lower P/E than a 'new born' which is valued on expectations rather than actual profits.

    If I hire a kid just out of college for 80k, am I paying for current performance or my expectations of future performance? If you want current performance you hire proven talent. If Johnson and Johnson had a P/E over 200 I think it would be time to sell. 3D at 40 still looks like a buy to me.

  • Report this Comment On May 12, 2012, at 11:19 PM, TMFCheesehead wrote:

    @wrenchbender-

    Exactly right on length constraints. I'm sure if we thought most people would read to the end, a lot of articles would be double or triple in length, but my goal is to make one succinct point: rely on more than just P/E in cases like these three.

    Definitely points out there's room for a follow-up to this article.

    Brian Stoffel

  • Report this Comment On May 12, 2012, at 11:55 PM, HistoricalPEGuy wrote:

    It feels like HistoricalPEGuy should chime in here...

    P/E ratio is by far the best metric you can use to valuate a company --- that is, a company that grows very consistently, at the same rate, year over year. MMM is probably the poster boy for using P/E. When a business is rock solid, P/E gives you a fantastic gauge to determine its valuation.

    Got a stock that's growing 50% a year with no earnings? Throw P/E in the trash. But wait, what if you stop for a second and push sales and marketing to zero as well as R&D. It isn't perfect, but can give you an historical look on how this newly calculated P/E can value a high-flyer.

    The P/E ratio is a beautiful metric, but you have to be smart on how you use it. Many things corrupt this single metric, but take the time to adjust it for yourself and make a call.

    One last point, Forward P/E is one of the worst metrics you could possibly use. Analysts are about as good at picking winners as a coin flip, so do your own research and make a call on what next year's revenues and earnings will be.

    -- HPEGuy

  • Report this Comment On May 13, 2012, at 9:48 AM, natgas2012 wrote:

    @historicalpeguy-

    Excellent thoughts on working out R&D and SG&A. Of course, for some companies (technology especially) R&D is the key to the future.

    That being said, having a tool box of metrics to choose from is important and I think this is a good one.

    Brian Stoffel

  • Report this Comment On May 13, 2012, at 12:29 PM, getrichdietrying wrote:

    700 time PE and it is bound to lower a "little", yeah and pigs fly when you throw em out the high rise window.

  • Report this Comment On May 13, 2012, at 1:05 PM, starboy340 wrote:

    so how about the other side of the argument. wish the author would address a company like AERL that earns $2.00 yet has a price of $5.26, and pays dividends. that's a p/e of under 3. what's wrong with this stock?

  • Report this Comment On May 13, 2012, at 2:18 PM, Freependragon wrote:

    AERL has very good ROA and ROE. Good growth of earnings too. But, it has huge debt equal to half of annual sales and has a negative cash flow and ....and....and above all, it is a Chinese company. I would not touch it.

  • Report this Comment On May 14, 2012, at 8:19 PM, BlkSqrl10 wrote:

    @TMFCheesehead-

    Great points. Another common example of where P/E would not be a useful tool is for companies with negative earnings. You touched on this when talking about new companies and companies that are investing earnings internally. You can also see negative earnings if the company writes off non-hard assets such as goodwill or takes a hit when they lose a lawsuit. In some of these one-time-loss situations, the earnings are affected for that year but could return to normal next year. The negative P/E ratio would not be useful in valuing these companies.

    In 2001, Amazon was trading at around $11/sh while its earnings were -$0.44/sh (P/E= -25). It now sells at $223/sh. I understand it might have been hard to value Amazon then, but if you relied solely on P/E, you would not have considered Amazon a good opportunity.

  • Report this Comment On May 17, 2012, at 1:05 PM, mrudolph72 wrote:

    @TMFCheesehead

    Please forgive my choice of wording in my earlier comment. It was inappropriate,

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