When Is A Stock Too Expensive?

Good morning!

If you read or listen to the financial media, you will hear the word “overvalued” quite often – especially when it pertains to companies in mega-growth industries, such as artificial intelligence (AI), the cloud, streaming video, blockchain technology, genomics, and financial technology (fintech).

If you use traditional metrics to measure the value of a company, these businesses would indeed be considered overvalued.

The standard way we calculate a company’s value is by their P/E ratio. P/E stands for “price to earnings”.

Simply put, we divide the price of the stock by the earnings per share (a company’s profit or loss).

For example, suppose a company earned $2.00 and has a price of $20 per share. We would calculate the P/E as follows:

Price per share/Earnings per share = PE ratio

$20/2=10

The P/E ratio in the above example would be 10 times its earnings.

Here’s where using P/E ratio to value stocks gets complicated: Growth stocks will usually trade many multiples above their earnings, and that’s even if they have any.

One of the reasons many investors missed Amazon (NASDAQ: AMZN) and Netflix (NASDAQ: NFLX) is that their P/E ratios defied the norm. The growth potential for these companies was so amazing that they traded at P/E ratios of 100 to 200 times earnings, which is considered expensive by normal metrics.

What we have to understand, however, is that a growth stock is a different animal. The focus by investors should be on how much its market cap can grow, rather than on its P/E.

A few years ago, Catherine Wood from ARK Invest said that Amazon was a trillion-dollar idea. At the time, the company was valued at $200 billion.

Her reason for saying this was that Amazon’s total addressable market was in the trillions.

As it turns out, she was right! Today, Amazon has a market cap of $876 billion – and it touched a trillion late last year!

If you’re like me, and invest primarily in growth stocks, then you cannot be afraid to buy stocks with high P/E ratios. When it comes to growth stocks, that’s the nature of the beast.

 

My book, The Stock Market is For Everyone, is a short guide for the beginning, inexperienced investor that is easy to understand and can be put into action immediately.

Click the image of the book at left to be taken to its Amazon page.  (Disclosure: As a participant in the Amazon Services LLC Associates Program, I earn a small commission on each sale generated through these links.)

 

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