Q: The P/E ratio is the most common valuation metric I see, but some stocks trade at ridiculous P/E ratios of 100 or more. How can these stocks possibly be good investments?
It's true that the price-to-earnings ratio, or P/E, is probably the most commonly used valuation metric, but that doesn't mean that it's a good way to gauge an investment in all cases. Some solid stocks have P/E ratios that are deceptively high, while other perfectly healthy companies may even have negative P/Es. When it comes to assessing whether such stocks are over- or undervalued, other factors come into play.
Three metrics that are particularly useful to look at in these cases are: the revenue growth rate; the PEG ratio, which factors a company's projected earnings growth into the P/E calculation; and the price-to-sale ratio or P/S. It's often the case that even if a stock's P/E looks extremely high, one or both of these metrics will make it look cheap.
To illustrate this, let's consider one excellent and well-known example: Amazon.com, which trades at a P/E ratio of 245 times its last 12 months of earnings. Looking solely at that metric, the shares might appear extremely expensive. However, Amazon's revenue grew by nearly 25% over the past year and, it trades at a P/S ratio of 3.1, which is roughly half that of its peer group. In other words, the company is highly valued relative to its current profits, but not relative to its sales or growth -- two factors that are indicative of its future profit potential. Also, Amazon has a PEG ratio of 6.4. That's above its peer average of 3.7 -- and well above the range of 0 to 1 that many experts seek in a stock-- but it's still a much more reasonable-looking valuation for a rapidly growing company than you'd find by looking at its P/E ratio.
So, while Amazon may look insanely expensive solely on a P/E basis, it's important not to simply dismiss stocks like this as "expensive" without looking at other metrics as well.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Frankel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.