Q: HOW HIGH IS TOO HIGH?
Why some stocks trade at sky- high P/ E ratios
A: It’s true the price- to- earnings ratio, or P/ E, probably is the most commonly used valuation metric, but that doesn’t mean it’s always a good way to gauge an investment. Some solid stocks have P/ E ratios that are deceptively high, while other healthy companies might even have negative P/ Es.
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 priceto- 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.
Consider one example: Amazon. com 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 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 many experts seek — but it’s still a much more reasonable- looking valuation for a growing company.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool owns shares of and recommends Amazon.