Stocks with high P/E ratios are very risky investments. If the company’s growth begins to dwindle before analysts expect, you can suffer huge losses. If the company meets or exceeds its growth expectations, you can gain a nice return. There is a high demand for innovative, high-growth companies, and investors have shown that they are willing to pay a premium for high growth, which has sometimes resulted in huge returns. We have also seen investors overpay for expected growth, which results in the many burst bubbles that we have all witnessed. In this article, I discuss three companies with high P/E ratios, and the risks and rewards that investors may face from buying their shares.
Amazon (AMZN): Amazon has been identified as a high-growth company for some time now. Amazon’s release of the Kindle has brought it from a successful internet retailer to an innovative tech juggernaut, and has left booksellers in the dust. Its current P/E ratio is 81.7, but many analysts still believe that their shares are undervalued.
Amazon has huge growth expectations over the next two years. However, this growth could be halted if the Kindle experiences decreased sales from new competitors or a loss of interest from consumers. Although Amazon is responsible for the vast majority of booksellers’ and other retailers’ downfalls, there is still some chance that it may follow and begin to lose earnings from increased competition and lowered margins. However, they could also enter new markets with their reach and popularity in the electronics industry and continue to innovate and grow, earning huge returns on their massive investments over the past few quarters.
VMware (VMW): VMware is good company that has the potential to be a big player in the technology sector, but is also one bad quarter away from losing substantial value. With a P/E ratio of 62.5, VMware is a leading player in the vastly growing markets of virtualization and cloud computing. It is about 80 percent owned by EMC Corporation.
If VMware can build a reputation among top corporate clients, like Oracle and SAP do with their enterprise products, it can easily meet its earnings estimates. However, earnings needs to have substantial growth for more than two years, and the long-term growth prospects of VMware are questionable with large, cash-heavy tech giants always looking to enter new markets. An investment in VMW is a large bet on the upside of VMware’s potential, and the belief that EMC will hold on to VMware, because EMC’s business relationships can really boost earnings for VMware.
Baidu (BIDU): Baidu is the sixth most visited website on the Internet, and specializes in web services for China. It currently trade at a P/E ratio of 60.3. With the Chinese economy growing, Baidu has strong growth potential and has a lot of earnings potential over the coming years. However, investors will only realize returns on Baidu if it can become the real “Chinese Google,” which is not an easy task. This entails not only holding market share in the Chinese web services industry, but also utilizing its services in as many ways as possible to maximize the user experience as well as advertising revenues.
I doubt Baidu will be a $200 billion company like Google any time soon, but it has a good chance of holding its position in the Chinese web services market and growing substantially as Chinese consumers become more connected.
I tend to stay away from stocks with high P/E ratios in bear markets, because there are usually much better values in the market, and investors tend to sell off stocks that trade at the highest earnings multiples first, because they have lower floors. However, I believe that these are three of the better high-P/E-ratio stocks out there.
If you believe in any of these companies’ business models and their long-term growth potential, I suggest you buy them now before the market bounces back. I recently wrote an article on some high-P/E-ratio stocks I do not like, and it is fairly obvious how much more value Amazon, VMware, and Baidu can provide.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.