It's Almost 2012, Start Interpreting P/E Ratios Properly

by: Rocco Pendola

Fellow Seeking Alpha contributor Simit Patel wrote something in a recent article about (NASDAQ:AMZN) that piqued my interest:

But in my opinion, there is a dealbreaker here, which is Amazon's P/E ratio; it's an astounding 92.59. The all-time high in terms of the average P/E of the S&P 500 is just over 45, which occurred during the dot com bubble. While I do think another bubble in U.S. equities is quite possible, I think a P/E of 92 is still quite high, and disqualifies Amazon from being a great investment opportunity -- in spite of the promising and immensely disruptive trajectory its tablet strategy is on.

First, I don't think Amazon's tablet strategy will disrupt anything that Apple (NASDAQ:AAPL) is doing. I've explained this every which way in the recent articles I have written about Amazon. But that's not my main beef. I take issue with what Patel said about Amazon's P/E ratio.

The way people use P/E ratios intrigues me. Actually, it baffles me. For many investors, a high number means "Stay away from this stock, it's overvalued," while a low number means, "This is likely a great value."

This traditional view of the P/E ratio obviously works for some investors. I just think it's an old way of doing business that ignores what a company is actually doing with its business.

Here's how I view and use P/E ratios in thought/bullet form:

  • I do not see P/E ratios as a measure of valuation, rather I view them as measures of investor confidence. Investors believe stocks with high P/E ratios, relative to an industry or some other benchmark, will be able to grow earnings at hyperspeed for the foreseeable future.
  • As such, hyper-growth companies do not "grow into" a P/E ratio. Companies that remain in hyper-growth mode will always have high P/E ratios.
  • That said, I pay little attention to forward P/E ratios. In fact, I expect that number to grow as, taking a traditional view of valuations, the stock price of a great company gets ahead of itself, and rightfully so, as earnings continue to grow.
  • When I see a "high" P/E ratio, I dig into the company's business. If I have reason to believe that current earnings growth will not only keep pace with history but accelerate, I don't buy into the valuation; rather, I share the confidence of fellow investors who have valued the company's stock at a particular price.

I have studied Amazon's various revenue streams. I feel as if I have a pretty good handle on where the company is going and how it is getting there. Based on that assessment, I share the confidence of buyers who value AMZN at $210 a share and going higher.

On the other hand, when I look at Best Buy (NYSE:BBY) its P/E ratio of 7.78 tells me that investors have little confidence that the company can grow earnings at a strong and fast enough clip to warrant a higher number. It's not only that I disagree, but I tend to take a longer-term view on companies in Best Buy's position. While I acknowledge the headwinds the company faces (PC market pressures, sales shifting online, uncertain economy), I anticipate execution to lead to stronger and faster earnings growth, which, in turn, should lead to a higher P/E ratio or, better yet, a more formidable level of investor confidence.

When I see relatively lofty P/E ratios on stocks I am bearish on, I don't think "overvalued," I think "overconfident." For instance, at 54.08 and 41.95, respectively, I look at Netflix (NASDAQ:NFLX) and Sirius XM (NASDAQ:SIRI) and say to myself, there's no way these companies can grow at a clip that justifies such a high level of confidence relative to the broader market. The research I've done into each company's business suggests growth has or will hit a wall and may even retreat in the foreseeable future.

There's a fine-line, but important distinction between calling a company "overvalued" simply because it sports a spiffy P/E ratio and evaluating its growth prospects within the context of investor confidence. After the dot-com bust of 2000, plenty of investors remain shell-shocked or, at the very least, way too cautious. There's a difference between learning from the past and letting it scare the heck out of you. When the latter emotion (and it's a very emotional process) takes over, you run the risk of missing out on the blue chips of tomorrow simply on the basis of unfounded fear.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. At the time of this writing, I own no positions in any of the stocks mentioned in this article, however, because I day and swing trade stocks, primarily using technical analysis, I may open and close positions in any of the stocks mentioned, often using options, at any time.