I have written before about my cautionary approach to a company with a sky-high P/E ratio like Amazon (NASDAQ:AMZN), which currently trades for around 186x earnings. When I started looking at other firms with high P/Es, I realized that I didn't like them either as potential investments. I don't want to buy shares of Red Hat (NYSE:RHT) for 75x earnings. And don't even get me started on Groupon (NASDAQ:GRPN). Maybe it's because I've been reading too much Benjamin Graham lately, but I'm strongly leanings towards never paying more than 20-25x earnings for shares in any firm's stock.
And I came to realize why I feel that way: if I were to invest $10,000 into Amazon at the current price of $227 and buy 44 shares of the online giant, I would effectively be paying for eggs that haven't hatched yet. I would be making my investment not based on the current practices of the firm, but rather, based on the belief that something will dramatically change in the future that will make the business more profitable-either the company will get fatter margins, launch new products, gain market share, etc.
As if the mentality of betting on not-yet-hatched eggs is not risky enough, I also have to assume that the long-term future profits will be enough to offset the likely P/E ratio compression that will occur over the long-term. What's a fair rate to guess that Amazon earnings will be capitalized at ten years from now, twenty? Think of it like this: if Amazon were to trade at 20x earnings ten years from now, the company will have to raise its annual earnings from the current $1.21 per share to $11.38 per share a decade from now for the investors to break even from the P/E compression. I don't want to rely on that many unhatched eggs turning into chickens just to break even ten years from now.
That's why I spend most of my time writing about mega-cap dividend growth firms like Coke (NYSE:KO), Johnson & Johnson (NYSE:JNJ), Conoco Phillips (NYSE:COP), and Procter & Gamble (NYSE:PG). When you invest in those companies, you get some hatched chickens to begin with-I'm not betting on some dramatic improvement in the future, but rather, I'm asking the companies to keep doing what they have been doing. As a potential investor, I could buy 100 shares of Johnson & Johnson right now for $6,400. If Johnson & Johnson decided to pay out all of its earnings as dividends, I would receive $363 in annual income. Instead, the shareholders entrust the management to retain less than half of the company's earnings to create more profits in the future, but I will be receiving $244 annually right now for my share of the company's profits. The difference between buying shares of Amazon and Johnson & Johnson is the difference between speculating and investing.
When you invest in Amazon for the long-term, you're effectively saying, "A whole bunch of eggs in the future will hatch, and that's how I'll make my money." But when you invest $6,400 into Johnson & Johnson, you get $244 worth of annual chicken income from the start. When you buy a dividend growth firm like Johnson & Johnson, you don't have to wait for any eggs to hatch to reap the benefits of your investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.