If Not P/E, Then What?

Last week, I wrote an article on when to ignore a company's price-to-earnings ratio. In a nutshell, the popular metric can become skewed when a company is just becoming profitable, or when it's temporarily spending lots of money to build an impenetrable moat around itself.

Avoiding high P/E stocks, I argued, also eliminates the chance to own some of today's greatest companies, as investors are usually willing to pay a premium for such greatness.

While readers appreciated the article, they were left wondering what metrics should be used when P/E doesn't matter. Below, I'm offering up one of my favorite alternatives to supplement standard metrics. At the end, I'll offer you access to a special free report on our favorite rocket stock that has a P/E worth ignoring as well.

Mind-boggling growth
Sometimes, a company has a P/E above 30 because the type of growth that it's exhibiting is astounding. Of course, the market is always forward-looking, so one could argue that we should be focusing on future growth -- not past performance. But as user HistoricalPEGuy pointed out, "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."

Therefore, I look to how much earnings growth the company has shown over the past three years and juxtapose that against its P/E to get a better idea whether I'd be paying too much for a company. Though there's no hard-and-fast rule, one school of thought is that a company's P/E should be roughly equivalent to its growth rate.

Focus internationally
In order to justify a P/E over 30, a company needs to be growing earnings by at least 30%. That's no small feat, but when you're focused on emerging markets, it becomes a little bit easier. Both MercadoLibre (Nasdaq: MELI  ) and Baidu (Nasdaq: BIDU  ) have been able to capitalize on the newfound wealth of Latin America and China, respectively. Take a look at the earnings growth over the past three years.

BIDU Earnings Per Share TTM Chart

BIDU Earnings Per Share TTM data by YCharts

Baidu, the dominant search engine for Chinese Internet users, has been growing by leaps and bounds. Even though some analysts are worried that the company's growth may be slowing, today's P/E of just 36 is very low considering earnings have gone up at an average rate of 75% over the last three years.

MercadoLibre, on the other hand, has been capitalizing on the strong economic growth and adoption of the Internet in Central and South America. The company functions as an online marketplace much the same way that eBay does in the United States. Though today's P/E of 40 may look expensive, earnings have grown at a rate of 60% over the last three years.

Another company focusing internationally -- though not necessarily in emerging markets -- is priceline.com (Nasdaq: PCLN  ) . Though we'd like to claim William Shatner as our own, the company does about 60% of its business in Europe. The company continues to wow its doubters, and the market has given it a P/E of 30, while its earnings growth rate over the last three years sits at 55%.

Two more fast growers
Some fast growers do the bulk of their business in the United States. Riverbed Technology (Nasdaq: RVBD  ) and lululemon athletica (Nasdaq: LULU  ) are two such examples. Take a look at how earnings have progressed for the two companies over the last three years.

LULU Earnings Per Share TTM Chart

LULU Earnings Per Share TTM data by YCharts

Clearly, Lululemon has been the faster grower here. The company has been capitalizing by focusing on both a yoga trend that was going unnoticed and on wealthier middle-aged women who had yet to be targeted so exclusively by such a company. Some could argue that a P/E of 56 looks ridiculous, but when you see that the company has grown earnings at an average rate of 70% per year for the last three years, it's not so outlandish.

Riverbed, on the other hand, makes its money by focusing on data. As fellow Fool Tim Beyers explained when purchasing shares of the company, "[Its] technology strips away unnecessary bits in transferring data over a network. The idea is simple: Make data lighter, and it'll travel faster." With our world becoming ever more wired and connected, companies that can make data travel a smoother course will be big winners. Though the company trades with a P/E of 49, earnings have grown by 82% over the last three years.

A word of caution
By no means am I saying that any of these companies are screaming buys right now. I'm just pointing out that by looking at a company's growth rates, and doing a little homework on their future prospects, a P/E over 30 no longer seems like such a sky-high valuation. Stay tuned, as over the next two days, I'll be introducing other metrics I use to supplement a company's P/E.

Usually, these types of metrics are used on companies that are fast-growing up-and-comers. We have a name for such companies: Rule Breakers. Our top analysts have just released a special free report on their favorite rule-breaking stock right now: "Discover the Next Rule-Breaking Multibagger." Hurry and get your copy today, absolutely free!

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

The Motley Fool owns shares of Baidu, Riverbed Technology, priceline.com, MercadoLibre, and lululemon athletica. Motley Fool newsletter services have recommended buying shares of lululemon athletica, priceline.com, Baidu, eBay, Riverbed Technology, and MercadoLibre. 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 (4) | Recommend This Article (7)

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 15, 2012, at 7:52 PM, Wade32ru wrote:

    Looking at the past 3 years growth is good practice, but you just can't ignore expectations on FUTURE growth. GMCR is a good case in point. Take the street consensus on future growth and do your own reality check and see how it compares to the past 3 years. Good read, thanks

  • Report this Comment On May 15, 2012, at 10:35 PM, TMFCheesehead wrote:

    @Wade32ru-

    Totally true, that's why I included this last tid bit at the end: <<doing a little homework on their future prospects>>

    Brian Stoffel

  • Report this Comment On May 16, 2012, at 12:59 AM, HistoricalPEGuy wrote:

    Brian - thanks for the quote. I love the conversation on how to value high-flyers. It is deeply misunderstood and you are shining a very nice light on the subject.

    Nicely done.

    -- HPEGuy

  • Report this Comment On May 17, 2012, at 11:56 AM, p0110ck wrote:

    since the requirement to subtract an expense for stock option, P/E has become a very unreliable metric for fast growing companies - especially for recent IPO's. It is worth taking the time to calculate the non GAAP P/E when non GAAP data is given. I have seen the P/E over 100 shrink to <10 using non GAAP earnings. This explains the disparity between apparent poor earnings but excellent cash flow with GAAP data and why such companies include non GAAP data in reports - it is a much better performance indication. Riverbed (RVBD) is such a company.

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