A Stocks and Shares ISA offers exemption from taxes on capital gains. That’s a big advantage, but only if investors can find stocks to buy that increase in value over time.
Stocks with strong growth prospects often trade at high price-to-earnings (P/E) multiples. That can put people off buying them, but I think avoiding high P/E stocks in general is a mistake.
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P/E ratios
Other things being equal, it’s better to buy shares at a low P/E multiple than a high one. But it’s rare that other things are equal and there are often more important things to consider.
Diploma‘s (LSE:DPLM) an excellent example of this (though not the only one by any means). The stock’s up 133% over the last five years, making it one of the best-performing FTSE 100 stocks over that period.
Back in December 2019, the stock was trading at a P/E multiple of around 35. That’s a lot higher than the FTSE 100 average, but that doesn’t seem to have held the share price back.
The reason is Diploma’s growth over the last five years has more than justified the share price. Sales have grown at an average of 20% a year, generating spectacular results for investors.
Acquisitions
Diploma’s a distributor of industrial components. And a lot of its growth since 2019 has been the result of acquiring other businesses and adding them to its network. The obvious risk with this is the possibility of overpaying for a business. Even an investor as good as Warren Buffett can make mistakes when it comes to valuing potential targets.
This is something investors should take seriously and the high P/E multiple means the firm doesn’t have a huge margin for error. But it’s also important not to overestimate this risk.
The inherent risk of paying too much for an acquisition has been a constant with Diploma. But it’s fair to say the company’s leadership has done an outstanding job of managing that danger.
Value investing
A lot of investors – especially value investors – might think paying 35 times earnings for a stock is out of the question. But that can be an expensive mistake to make.
When a company has outstanding growth prospects, its shares trading at a high P/E ratio can be justified. This is what the example of Diploma demonstrates over the last five years. The 145.8p per share the firm reported in 2024 represents an 8.5% return on an investment made in 2019. And with profits still growing, buying the stock back then looks like a good idea.
Future growth’s always uncertain and investors need to work out which shares justify a high multiple and which don’t. But a policy of avoiding stocks just based on P/E ratios is a bad one.
ISA opportunities
A £10,000 investment in Diploma shares five years ago would have a market value of £23,423 today. The same £10,000 invested in the FTSE 100 would be worth £11,474.
That doesn’t include the dividends, but this doesn’t make up for a difference of over 119%. And with a Stocks and Shares ISA, investors can hang on to all of those gains.
