A high price-to-earnings ratio isn't necessarily a sign of overinflated value.
A lot of technology companies have a high P/E ratio and in the long run, those numbers make sense. Of course, in some cases they can be a warning flag as well, so understanding the metric helps you make the best decisions about applying it.
In this clip from the Industry Focus: Tech podcast, Motley Fool analysts Dylan Lewis and Simon Erickson talk about two reasons a company might have a high P/E ratio, and why investors shouldn't let a high price-to-earnings number scare them away from an otherwise appealing stock.
A transcript follows the video.
This podcast was recorded on Jun. 3, 2016.
Dylan Lewis: Simon, this being the tech show, we cover an industry with a lot of high-flying P/Es. I thought it would be really awesome to talk about a couple of companies in this space that have illustrated some of the merits of this approach: looking at these high P/E companies that have done pretty well for investors, and then maybe talk about one that you're particularly excited about now, that's maybe a little bit under the radar.
Simon Erickson: Great.
Lewis: I wanted to bring you on the show because I know you focus on tech, and I think that this space is particularly prime for this type of investing approach. You have a couple of reasons for that.
Erickson: Sure. Again, when we're talking about the E in the P/E ratio, this doesn't account for a lot of things that a lot of tech companies are plowing back into the business, which is decreasing the E, which is inflating the P/E ratio -- if I haven't confused everyone with that analogy there.
Lewis: There's a lot of rhyming and letters going on there.
Erickson: It's companies that are investing more in themselves. The first reason for that is really kind of cloud-based computing. Companies are spending very heavily on servers and a lot of IT infrastructure for hosting things in the cloud. More and more software is moving this way. When you spend a lot of money upfront on those servers and infrastructure, you have to depreciate that over time. Depreciation reduces your earnings over time too, so you have less reported earnings in the short term, but a huge benefit over the longer term.
The second thing we've really seen in the tech industry, also, is there's kind of a favor of, or preference of, paying employees, especially developers, in stock. Stock-based compensation is an expense which is not a cash expense -- a lot of these companies are still producing a lot of cash flow -- but it does work against your earnings too. Companies that pay their employees in stock rather than in cash, that tends to be a lower P/E -- I'm sorry, a higher P/E -- lower-earnings company that's still pulling in a lot of cash on the licenses. So there are two things that particularly pertain to the tech industry for this.