Last year, before the stock market sold off, the prevailing thought among many pundits was that stocks were overvalued.
What makes a stock overvalued is very subjective.
Some analysts look at a stock’s price-to-earnings ratio, also known as the PE ratio. You take the price and divide it by its earnings per share. So if a company has a PE of 20, that means that it’s trading at 20 times earnings.
You can also look at something called a price/earnings to growth ratio, or PEG ratio. A PEG ratio of 1 or less indicates that the stock is undervalued.
Now, I personally use neither of these to decide on my stock selections. My main concern is the size of the company versus the size of the opportunity.
Amazon (NASDAQ: AMZN), for example has always traded at sky-high PE levels. As a result, many investors passed on it because it was too expensive.
In 2015, Catherine Wood, the founder of ARK Invest, said that Amazon was a trillion-dollar company because the market opportunity was in the multiple trillions. Amazon had a market value of $200 billion at the time and its PE was over 100 – insanely expensive by traditional metrics. However, the stock flirted with a market value of a trillion and I’m confident it will get back there.
Great businesses with incredible growth opportunities will always seem expensive, but don’t let that stop you.
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.)