The P/E ratio is a time-honored way to value stocks but in today’s market P/E ratios are sky high. Is a high P/E ratio dangerous? The P/E ratio compares company earnings to its share price. Both forward and trailing P/E ratios are commonly used to assess stock valuation. Over the years, a stock that has a P/E ratio higher than other’s in its market sector is either expected to grow or is simply overpriced. The problem today is that so many stocks have high P/E ratios, which casts doubt on the value of this metric.
Why Are P/E Ratios So High?
Over the years the average P/E ratio for stocks in the S&P 500 has been between 13 and 15. When earnings go up the P/E ratio goes down. Investors buy and the P/E ratio comes back up. But, why are P/E ratios so high today? Tesla has a P/E ratio of more than 1,000. Amazon has a P/E ratio of 120. Netflix has a P/E ratio of 83. Apple has a P/E ratio of 17. Why are P/E ratios so high for Netflix and Tesla? The reason is that enough investors believe that Tesla will become the dominant company in the electric car industry and that Netflix will dominate the streaming content niche. In addition, with interest rates at historic lows, even over-priced stocks can look attractive.
Disadvantages of Using P/E for Valuation
During a bear market the P/E ratio of a stock may be misleading. When we consider the intrinsic value of a stock, we look to the future and not the immediate present when the business cycle has slowed down. And, a steadily growing stock that is coming to dominate its market niche will typically have a high P/E ratio as investors want to get in before the price goes even higher. But, if a company is really failing and its stock price is falling, the P/E ratio may mislead investors into thinking that the stock is stable.
P/E and PEG Ratio
When you are factoring growth into the equation for a stock, the PEG ratio can offer more insight than the P/E ratio. The PEG ratio is the price and earnings to growth ratio,
PEG = (P/E ratio/Annual Growth Rate)
In the best of all possible worlds, the PEG of a fairly priced stock should be one. Market Watch writes about the “three stock markets” and warns that FAANG stocks with high P/E ratios are overpriced, stocks traded by the Robinhood investors are crazy, and the rest of the market has value if you can find it. Their observation is that the P/E ratio makes sense in the broader market while the FAANGs are priced too high and the choices of most Robinhood investors make little or no sense.
If you are interested in a stock like Tesla, a better approach than the P/E ratio is to compare their progress to that of companies like General Motors, Ford, and Volkswagen. The winners in the race to dominate the electric car market will necessarily be the ones that are flashy today but the ones who are most efficient and profitable in the long run.
Is a High P/E Ratio Dangerous? Slideshare Version