To find out if a company represents a great investment, many investors divide its share price by its earnings per share, giving the price-to-earnings (P/E) ratio. As a rough rule of thumb, anything less than 10 suggests a share is cheap. Ratios in the teens suggest fair value. Anything above 20 looks expensive.
But there's a problem. Some private investors may fixate on the P/E to such an extent that they neglect far better companies which, thanks to their growth potential, trade at what would normally be considered high (or exceedingly high) valuations. The result? Portfolios become stuffed with very average holdings (or worse), making dreams of early retirement distinctly unrealistic.
Our attachment to the P/E (based on historical or forecast earnings) is understandable. Faced with overwhelming amounts of information and the need to make a decision, it's normal to take cognitive 'short cuts'. While I'm not suggesting that all highly valued companies are of equal quality or without risk, I do believe that only following the aforementioned rule may drastically reduce your returns. Let me explain.
What goes up... keeps going up
Since 2010, Domino's Pizza (LSE: DOM) P/E hasn't dipped below 22. Back then, its shares were priced around 100p. Thanks to canny marketing, the company is now the dominant player in its industry. The price now? 354p.
Look at the valuation history for Rightmove (LSE: RMV) and you'll see much the same thing. Since 2010, its P/E hasn't budged below 22 and yet its share price has soared around 800% thanks to it becoming the first point of call for prospective house buyers.
The US offers even more striking examples. Amazon (NASDAQ: AMZN) has a long history of astonishingly high P/Es (currently 207) and yet the company is now the fourth largest in the world by market capitalisation. Apple(NASDAQ: AAPL) once traded on a P/E of 297 but, thanks largely to the iPhone, it now stands at just 14.
In short, all of these companies have been highly valued for years and yet their share prices have kept rising due to the quality of the underlying businesses and their ability to consistently grow earnings. Investors that managed to resist looking at their respective P/Es in isolation and paid more attention to their future prospects would have done very well indeed.
Sure, there's an element of survivorship bias about this. Many companies hit lofty valuations only for their share prices to plummet on the first sign of trouble. We only need to recall the dotcom boom and bust for evidence of when things can go seriously wrong. But this is why it's important to look at a prospective investment from many different angles.
Appreciate the bigger picture
While the P/E should be respected, it's just one part of the puzzle that is evaluating a company and its future prospects. A proper evaluation of any business should consider other metrics such as return on equity (ROE), cash flow and how much debt the company carries.
In the style of investment guru Peter Lynch, don't neglect looking beyond the numbers either. Are there other signs that a company is thriving? Does it have a promising pipeline of products that you couldn't do without? Is it set to disrupt an industry?
Bottom line? Don't automatically assume that a high P/E signals overconfidence or irrationality. Occasionally, it pays to pay more.
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Despite trading on a P/E of 24, this company has a long history of increasing earnings and excellent returns on capital. Indeed, it recently reported strong profits for the first half of 2016 despite difficult trading conditions causing many of its rivals to struggle.
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Paul Summers has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Amazon.com and Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool UK has recommended Domino's Pizza and Rightmove. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.