Don't Be Afraid to Pay a Premium, "Cheap" Can Always Get Cheaper

An investor friend has been eyeballing a 3D printing company, fascinated by the technology, and seeing big potential. But something's holding him back: the price-to-earnings ratio.

"It's too high," he says.

We're often victims of our own investing dogma. One of the most egregious articles of faith we follow is the insistence on certain metrics to back our bullishness. Example: A high-PE stock carries a bigger risk than one selling at a lower multiple.

Would investors have been better off buying Apple at a P/E of 15 or 45? If you bought when Apple was selling at a multiple of 45 in 2007, you could have ridden the stock to a 500% gain. Buying at the bargain-basement P/E of around 15 five years later could have earned you a 43% loss.

This underscores the value of a good qualitative argument as part of our investing decisions. While you can't predict with certainty what a company will earn five years from now, you can build a pretty sound vision of how it will drive growth.

On that note, let's take a look at three companies that get kicked around for having high multiples and see why investors are willing to pay up.

America's favorite growth story

Amazon (NASDAQ: AMZN  ) looks really expensive by almost any metric that accounts for earnings. Its forward price-to-earnings multiple is over 100. Still, even at sky high valuations, it's returned 60% to investors over the past two years. Its 5-year estimated PEG is nearly 9.12. That's stratospheric. Google sells at an estimated 5-year PEG of 1.37.

But investors are willing to overlook that valuation, and with good reason. Amazon has established such dominance that it's becoming harder to see how it could not succeed in the long run.

It's also continuing to stretch its tentacles into different areas, like cloud computing, and it's doing so without borrowing money. It might be keeping narrow margins, but it's using its cash flow to fund its own rapid growth. And then there's this: Amazon's new mobile advertising network is already reaping some $600 million in ad revenue. That's another game-changer for the evolving company.

Where it could go wrong:

Amazon is building warehouses to get customers a wider variety of goods faster. Same-day delivery is in the offing, at least in some major U.S. markets. Those warehouses cost money, not just to build, but to operate. It's hard to see how that won't zap margins in the retail area, still Amazon's bread and butter. Sales of merchandise make up 65% of overall revenue.

Amazon is a fast-evolving goliath. Bulls are willing to give founding CEO Jeff Bezos the benefit of the doubt that he's figuring things out with the long game in mind.

The social media company that's figured it out

You thought Amazon trades at a premium? It can't hold a candle to LinkedIn (NYSE: LNKD  ) , which trades at an earnings multiple of -- brace yourself -- 662.20.

Astronomical? Yes. But LinkedIn has been a true anomaly among social media companies. By focusing on the professional needs of workers and companies, it's figured out how to reliably make a profit, and it's done so fairly early in its existence. (The social network launched its public profiles in 2006.) It's been on a tear ever since it went public two years ago, giving courageous investors as much as a 266% return in short time. The most recent quarterly earnings swelled by some 76% over the previous year. While those numbers are impressive, they tell only a small part of the story. LinkedIn is still in its relative infancy.

The company has some 238 million members. Seems like a lot, but LinkedIn believes it has so far reached just 4% of its immediate potential market, which it estimates at $27 billion. What's more, LinkedIn has already established international appeal. In fact, it has twice as many users outside the U.S. as it does in the states. That bodes well for continuous growth. 

Where it could go wrong:

The landscape of social media changes with the weather. We've already seen many networks come and go, and the barriers to entry remain relatively low. It's important that LinkedIn build on the advantages it's established to gain a stronger hold on the market so it can weather the coming storms.

The eatery with a second course on the way

Gone are the days when Chipotle Mexican Grill (NYSE: CMG  ) was expanding its burrito empire and growing its earnings 40% year over year. In fact, the most recent quarter saw earnings per share up about 10%. That's good, but it makes Chipotle look awfully expensive at 43 times earnings.

It still has plenty of room to expand its burrito empire. It plans to add 165-180 more stores to its roughly 1,500 locations this year. And it has still barely touched foreign soil.

Still, more intriguing may be Chipotle's second act: ShopHouse . This Asian-inspired eatery has just a handful of locations. But it holds great promise, given Chipotle's stellar track record so far. Investors are willing to pay up because they believe there's an encore at the end of this show.

Where it could go wrong:

Just because Americans love Chipotle burritos doesn't mean people in all markets will. Foreign expansion is fraught with uncertainty. If Chipotle has a tough go internationally, the growth that investors are hoping for may be slow to arrive, if it comes at all.

Whether Americans embrace the ShopHouse line of restaurants is another question mark. Long-term investors will want to watch these areas in quarterly reports in the coming months and years.

The Foolish bottom line

Motley Fool CEO David Gardner imparted this piece of advice in a recent newsletter:

"...don't center your investing style on valuation work, confidently projecting future cash flow; better to think about where the world is going than whether a given P/E is rational."

It's a good piece of Foolish advice (of which you'll find plenty in the Fool's newsletters). And it's too seldom followed by investors who become so enamored with numbers that it puts them in the thick of the trees, unable to see the forest.



Read/Post Comments (5) | Recommend This Article (3)

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 August 26, 2013, at 10:03 AM, tmare wrote:

    This article about Amazon is irresponsible. The small investor who follows your analysis will eventually lose a lot of money when the big boys abandone this nonsensical valuation. Amazon is already get killed on price by regular bricks and mortar stores (immediate delivery). There has never been a successful stock that didn't deliver profits and Amazon never will. Even if Amazon beats every projection and delivers $5.00 EPS (which wont' happen for years)it's a $150 stock.

  • Report this Comment On August 26, 2013, at 10:14 AM, HowardStern666 wrote:

    if LNKD's addressable mkt. is $27 bil., if they captured 90% of that market and had margins of 50 % (10x current margins) they would make about $12 bil. in revenue a year. Take off 50% in taxes and you have net revenues of $6 billion, or 4x 2013 revenues.

    That would put it at a P/E of 40. Is that cheap?

    And that's 3 years from now

  • Report this Comment On August 26, 2013, at 10:18 AM, MFMotleyStool wrote:

    Typical Motley Fool nonsense. Never mind the horrible trend in metrics when considering ALL COSTS and not just cherry picking. Yes QE got good news today so therefore AMZN did. You know bad economic news is good for continuing QE and running MOMO stocks like AMZN up, up, up. This will be one of the bagholder stocks and I don't think it's terribly far off. Once it happens many of those that loved it will talk about the real metrics and not margins that don't include certain costs etc.

    The truth will set you free.

  • Report this Comment On August 26, 2013, at 10:55 AM, Mega wrote:

    Growth stories work great, until they stop working and blow up. No thanks. If I owned the companies recommended by TMF I wouldn't be able to sleep at night.

  • Report this Comment On September 01, 2013, at 8:51 AM, dvena wrote:

    Hi John - I am a big fan of buying on the way up as anyone who reads my posts will know. Some folks just don't get that you cannot use PE to valuate a growth story; it has never worked, it never will. I have seen how buying stocks that are "overpriced" has worked fantastically for over six years.

    Great article - ingnore the detractors. - Danny

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10/30/2014 3:59 PM
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