Pure numbers don't tell investors everything they need to know about a company's potential. Although many investors use the price-to-earnings ratio as a kind of shorthand for whether the market is pricing the business appropriately, the numbers are not always what they seem.
A company can decide that while it originally thought it was in a particular niche, it realizes there are more expansive definitions of what it does and that might not show up immediately on the bottom line, but over time it could come to define the business.
In this clip from the Industry Focus: Tech podcast, analysts Dylan Lewis and Simon Erickson talk about why fantastic companies that have enormous P/E ratios might still make for fantastic investments.
A transcript follows the video.
This podcast was recorded on June 3, 2016.
Dylan Lewis: That's really where a lot of these astronomical P/Es come in. You have companies in spaces that maybe don't even exist. A lot of the stuff that Amazon is currently doing, a lot of people probably wouldn't have conceived of five years ago. You look at what they kind of unveiled with their web services division and how incredibly profitable it is for them. That wasn't something people really had a sense of until they started disclosing the financials there. Part of the reason you see these high P/Es is just people don't exactly know where business is going or what's under the hood sometimes.
Simon Erickson: Perfect example, like you just said. Businesses learn what they're good at over time and can expand their market. Another one that I'll bring up is Uber. Private company. Not traded on the stock market, unfortunately, for publicly facing companies or publicly traded companies rather. This is a company that started as a ridesharing app in New York City, right? Black cars in New York City would pick you up and they realized they were an app company and not a car company and they started expanding that.
They said, "Hey, why don't we open this to more cities? Why don't we expand this to logistics, transportation rather than just ride sharing and stuff like this?" Now Uber is, you know, several tens of billions of dollars of market capitalization right now. It's a company that learnt where its niche was, learned what it was good at, and expanded those markets. A lot of that you'll see always at a high P/E ratio and definitely a Rule Breaker kind of company.
Lewis: If you're thinking about a company and what they're currently doing, the P/E Ratio, if it's high, is never going to make sense.
Lewis: Right? It's much more about what they could be doing and that's what you kind of have to pay attention to. If you see that the things that management is talking about or the opportunities that are available to a company in that kind of space can justify those types of valuations then it might be a company worth looking into. I think that's generally the way to think about some of these high P/E tech companies.
Lewis: Anything else, Simon?
Erickson: No, that's it. Check out our Rule Breakers website if you want to learn more about high P/E growth-y kind of companies. We do have the six signs of a Rule Breaker. You mentioned one of them that it's kind of historically overvalued in the media. You want to find the right companies to do that, too. You don't want to just go out and say, "Hey I'm going to buy every high P/E Ratio company out there." The devil is in the details of that. You have to really say, "But why is the P/E high on this? What is the future going to look like for this company?" We kind of try to spend a lot of our time identifying those competitive advantages and why this company is different than anything else that's unprofitable out there. That's the trick of Rule Breaker investing.
Lewis: To your point earlier, these high-growth companies, the high-P/E companies, they're not necessarily for everyone. Depending on where you are in your investing life, it might not make as much sense but it's just something to think about and consider for your own portfolio.
Erickson: That's right.
Dylan Lewis has no position in any stocks mentioned. Simon Erickson owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com. Try any of our Foolish newsletter services free for 30 days. 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.