What is a High PE ratio? Is it a good or bad investment?

Companies can and should be expected to improve upon their profits (that’s called company growth) and that’s why investors will pay a premium for a company (expectations for future earnings). But buying stock in a company with a high P/E ratio can often back-fire on the investor. High P/E indicates that Wall St. has already taken notice of the company and that you are buying in at a high-price (a premium). There is not much room for error: if the company slips up even a little bit, then there’s a lot of room for you to lose money.

Let’s consider the current Google phenomenon. The company has been trading above a P/E ratio of 50 (which reflects an expectation that the company will, sometime in the future, generate 50 times its currents profits). Investors have gone ga-ga over Google. Investor expectation is sky-high for the company and thus far, Google has not disappointed. But those investors who get into the game right now are betting that this trend will continue. They have super high expectations for Google as a company over the long term, but they are setting themselves up for profit loss if Google ever disappoints. Additionally, the technology sector and especially the search market are uber-competitive. If Yahoo or Microsoft start to take market share from Google, investors will be in big trouble. With a P/E ratio of 50, investors are literally betting on Google’s future. But at The Common Sense Investor, we believe that investing should be discipline and principled. By staying away from P/E ratios above 25 (and maybe even 20) you simultaneously cushion any fall and provide more room for profits.

P/E ratios are quite effective in seeing what you are getting for your money. Think of stocks as products. You don’t want to pay too much money for a gallon of gas, right? The same should apply for company stock. You want to buy stock at fair prices. In our view, a fair price should accurately reflect a company’s ability to produce wealth over the long-term. Cheap P/E does not necessarily mean the company is a good buy: poorly run companies can have low price-earnings ratio. P/E is only part of the puzzle for determining a good investment: other factors include return on equity, the company’s forward looking business plan, the company’s trend in market share, etc.

Investors who buy shares in a company with a high price earnings ratio are actually paying more in terms of earnings compared to investors who buy shares in a company with a low price earnings ratio. Knowing this information you might wonder why investors would still opt to buy shares of a company with a high price earnings ratio. The answer is simple. The price factor in the equation is frequently controlled by expectations. If an investor feels confident that a company will make increasing profits in the years to come he will be more likely to be prepared to pay more in order to partake a share of those profits. If the general outlook for the company is seen as static or risky then they are more likely to pay less. The thing to keep in mind when investing is that expectations don’t always reflect reality. High P/E ratios can reflect realistic expectations, but more often tend to reflect investor exhuberance (following the crowd: once Wall St. has taken notice, everyone rushes in and pushes the stock price high, which in turn raises the P/E).

Though the can reflect reality, very high price-earnings ratios can be dangerous because the expectations are so high that a small wrinkle in the company’s performance can be enough to send the share price falling. As mentioned earlier, low price earnings ratios do not necessarily mean a share is of good value either. It is even quite possible that investors are rightly avoiding the company because its general prospects are not good. A good tip here is to try and look for shares that are trading on relatively low price earnings ratios but have generally good growth prospects. This is known as a Growth at a Reasonable Price strategy and is both a safe and prudent way of investing.

Investors can also use the price earnings ratio to look for:

* Companies that have a low rating or are undervalued, for example, companies with a price earnings ratio of less than 15 or more than 4.

* Companies that are highly rated or overvalued, for example, companies with a price earnings ratio of more than 20.

* As a general rule of thumb (although there are plenty of exceptions), fair P/E ratios are typically in the 14-18 range.

One should always keep in mind that price-earnings ratios vary widely across different sectors. For example, at one point, the steels and other metals sector was trading on a price earnings ratio of 4.5, while the investment companies sector traded on a price earnings ratio of 54. Although it is always a good idea to frequently look at the price earnings ratio of the sectors you invest in, as a general principle, only invest in good companies at reasonable prices. You can identify “reasonable prices” by looking at the P/E ratio and you can identify growth prospects by looking at the companies return on equity. The last element in the puzzle is to make sure that the company is poised for continued growth in their market.

To conclude, the main reason to avoid company stock with high P/E ratios is that it provides you less opportunity to make profits and more potential for losing money. Although it is not a perfect analogy, you can think of buying stock with high P/E like buying at the peak of a market: and as we all know that the goal is to buy low and sell high.