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.
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.
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
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
Two more fast growers
Some fast growers do the bulk of their business in the United States. Riverbed Technology
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!
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.