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
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.
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