Any stock with a P/E of 50 or greater requires a serious second look at their earnings potential. As P/E's reach these levels or higher, it gets harder and harder to meet those expectations. Your potential returns also come into question because these types of stocks often can't maintain the share value growth to maintain those P/Es. More often than not, buying into stocks with excessively large P/E's offers little to gain, but much to lose. To get a better understanding of what I’m talking about, take a look at this chart.
Here are three particularly bad offenders that for some reason are suggested as buys. I'm not questioning here whether they are good companies or not, but whether they can reach the earnings that their P/E suggests they will get.
CRM currently trades at a P/E of about 650. If CRM manages continued growth of 25% per year, every year, for the next 13 years, and if the share price doesn’t change, CRM will have a P/E of around 30. So if CRM performs spectacularly over that timeframe, the share price should remain unchanged. Should CRM stumble even slightly, say 15% or 20% yearly growth, this stock will fall. The only way these shares are worth the $123 today is if you expect 30-50% growth every year for the next decade.
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If this is what CRM’s earnings look like over the next 13 years, the share price won’t appreciate in value until about 2025. CRM needs to beat these hypothetical earnings. If they don’t beat these quarterly earnings, the share price will lose value.
AMZN currently trades at a P/E of about 92. AMZN needs to continue its stellar growth of about 35% per year over the next 5 years just to maintain it’s current share price. This continued rate of growth suggests that AMZN will take in nearly $60 billion worth of sales in 4Q 2015. If you think that number is too lofty, you’re not the only one. Assuming you want your shares to appreciate in value by 2016, AMZN needs to beat these figures. So if you thought $60 billion was a long shot, try the $75 billion or so necessary in 4Q 2015 to validate its lofty P/E. That’s $30 billion more than its entire current TTM revenue, in one quarter.
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Kinder Morgan Energy Partners (KMP)
KMP currently trades at a P/E of about 120. At that P/E, the only good thing I could find was its impressive 6% dividend. If KMP traded at around 15 P/E like the average utility, its dividend would be an amazing 48%. Ask yourself how long can KMP keep that dividend up when it pays out more than double its EPS? In order to validate its P/E and dividend yield, KMP needs to octuple their revenue to about $15 billion per quarter. That’s 50% greater than their current yearly revenue. The dividend KMP offers just isn’t worth the risk of this stock missing expectations. Should KMP fall short, or be forced to make a cut to the dividend, the share price could plummet 50% within a year. Getting that one or two extra percentage points just isn’t worth it to me over a utility stock like Duke Energy (DUK) or Dominon (D).
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To get a better understanding of what I’m talking about, take a look at this chart.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.