The price-to-earnings (P/E) ratio is one of the most widely used valuation measures in the stock market. The ratio is relatively easy to calculate and tells investors what the market is willing to pay for every $1 of a company's earnings. The P/E ratio has also been proved to have a significant relationship with long-term stock returns, so despite its simplicity, it is a great starting point for starting stock analysis. (To learn more, check out our P/E Ratio Tutorial.)
P/Es of comparable companies should generally be the same, unless company-specific factors change the outlook of the company considerably. Coventionally, trading at a higher P/E suggests that the stock may be overvalued.
However, there are a few other considerations to think about. The high P/E company could be expected to grow revenue and earnings much more quickly in the future than a lower P/E competitor, thus commanding a higher price today for the higher future earnings. Second, suppose the estimated (trailing) earnings of the high P/E company are very certain to materialize, whereas the low P/E company's future earnings are somewhat uncertain, indicating a higher investment risk. Investors would incur less risk by investing in more certain earnings instead of less certain ones, so the company producing those sure-thing earnings again commands a higher price today.
Let's take a look at five big name stocks with high P/Es worthy of follow-up research.
|Company||Trailing P/E||Market Cap|
|Baidu.com, Inc. (Nasdaq:BIDU)||91.31||38.34B|
|Netflix, Inc. (Nasdaq:NFLX)||63.90||8.85B|
|VMware, Inc. (NYSE:VMW)||113.78||33.01B|
Buying a stock when its P/E is inflated is not necessary disastrous for investors. The most important thing to do is to determine the quality of the stock's future earnings. Having a high earnings growth potential may merit the higher than expected valuation.