Q: HOW HIGH IS TOO HIGH?

Why some stocks trade at sky- high P/ E ra­tios

Chicago Sun-Times - - AMERICA’S MARKETS - Matthew Frankel

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.

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