Why the P/E ratio may be killing your dreams of becoming a millionaire

Paul Summers argues that one of the most frequently used ratios should be just the starting point for further research.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

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.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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.

More on Investing Articles

Shot of a young Black woman doing some paperwork in a modern office
Investing Articles

With an 8% dividend yield, I think this undervalued FTSE stock is a no-brainer buy

With an impressive yield and good track record of payments, Mark David Hartley is considering adding this promising FTSE share…

Read more »

Passive income text with pin graph chart on business table
Investing Articles

£9,500 in savings? Here’s how I’d try to turn that into £1,809 a month of passive income

Investing a relatively small amount into high-yielding stocks and reinvesting the dividends paid can generate significant passive income over time.

Read more »

Businesswoman analyses profitability of working company with digital virtual screen
Investing Articles

Dividend star Legal & General’s share price is still marked down, so should I buy more?

Legal & General’s share price looks very undervalued against its peers. But it pays an 8%+ dividend yield, and has…

Read more »

Investing Articles

Dividend shares: 1 FTSE 100 stock to consider buying for chunky shareholder income

This company’s ‘clean’ dividend record looks attractive to me and I’d consider buying some of the shares to hold long…

Read more »

Investing Articles

3 of my top FTSE 250 stocks to consider buying before April

Buying undervalued UK shares can be a great way to generate long-term wealth. Here, Royston Wild reveals a handful on…

Read more »

Ice cube tray filled with ice cubes and three loose ice cubes against dark wood.
Investing Articles

Just released: our 3 top income-focused stocks to buy before April [PREMIUM PICKS]

Our goal here is to highlight some of our past recommendations that we think are of particular interest today, due…

Read more »

Investing Articles

Is this the best chance to buy cheap FTSE 100 shares in a generation?

I want to buy shares when they're cheap, and sell... never, just keep taking the dividends. And the FTSE 100…

Read more »

Man putting his card into an ATM machine while his son sits in a stroller beside him.
Investing Articles

Could NatWest shares be 2024’s number one buy for passive income?

For those of us looking to earn some long-term passive income, how does NatWest's 7% dividend yield sound? It sounds…

Read more »