High P/E Ratio
For beginning traders, we introduce a simple method of determining whether a stock price is fairly valued. This is done by taking the price of the stock and dividing it by the earnings per share (EPS.) The EPS is based on the company’s earnings over the last 4 quarters. The result of this calculation is called the P/E Ratio. We suggest that we would like to see a P/E under 20 to be considered fairly priced.
Another consideration is warranted as well. What if the company’s earnings are expected to improve? What if the last year was a bad year? What if the company is in the process of turning things around? We can than consider the Forward P/E Ratio, which takes the price of the stock and divides it by the forward, or projected earnings, for the fiscal year that is ending 1 year from the current fiscal year end. Again, we suggest a Forward P/E under 20 to be a fair price. Even better is the Forward P/E number to be lower than the P/E number.
The benefit of the Forward P/E is that it takes into consideration the expectations of the company going forward. A lot of companies with high P/E or even high Forward P/E numbers are companies that have high expectations for the future. The prices of the stocks are high due to market demand. The demand is due to high market expectations of great future growth from the company. These companies aren’t necessarily bad companies, but are higher risk. But they also have high potential. In fact, you might have a company like Tesla Motors that is expected to lose money this quarter and next but be profitable for year end and expected earnings growth from $.08 per share for the year to $2.37 per share the next year. These numbers will generate a high P/E once the company is profitable and it already has a high Forward P/E. Yet this company has already seen the stock price rise from $40 to over $200 in the last 15 months.
The risk with high P/E numbers can come with disappointing earnings. Netflix, back in 2011, was climbing its way to $300 when some disappointing news and earnings started coming out. The stock price dropped to near $60 in about 5 months. It has since climbed back to over $400. This illustrates the risk and reward of trading stocks with high P/E numbers.
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