Since the stock market crash in March, investors have become wary of which shares to buy. This has resulted in some sectors being avoided and others seeing high demand. Unloved sectors include travel, hospitality, oil and finance, while loved sectors include technology and pharmaceuticals. This has led to a lot of high-quality shares with ridiculously high price-to-earnings ratios (P/E). Think AstraZeneca (LSE:AZN) with its earnings multiple of 104, Avon Rubber at 86 and Games Workshop at 45.
As I consider buying these shares, I worry if a market correction occurs, I’ll have paid too much at a price point that’s unsustainable. This problem is not unique to the UK, it’s even more prevalent in the US, where Tesla has reached an astronomical P/E of 959.
A high P/E should signal quality
However, successful British fund manager Terry Smith recently said that a high P/E will not necessarily lead to future disappointment. This is because many companies doing well today previously had a high P/E and it would have been a mistake to avoid them for that reason alone. When a company looks strong and offers consumers and shareholders value, it could continue to do so.
A price-to-earnings ratio is calculated by dividing the current stock price by its earnings-per-share (EPS). When a company’s earnings increase, then the P/E will usually reduce.
The reason a company achieves a high P/E in the first place is because a deluge of investors buying it drives its share price up. If that many people believe in the stock, then surely this should signal a quality company? I think that’s what’s happened in AstraZeneca’s case.
Is the AstraZeneca share price too expensive?
The AstraZeneca share price has skyrocketed this year as it gets set to battle Covid-19 via its vaccine collaboration with Oxford University. AstraZeneca has a fantastic array of medicines already available and many more in the pipeline. It provides diversification through its variety of treatment types, and is enjoying product sales growth. It also offers a dividend yield of 2.5%, which may tempt long-term investors looking to add dividend stocks to their portfolios.
The trouble with pharma companies is they’re up against several factors, not least being a competitive marketplace. The economic backdrop can significantly influence share price volatility. And there’s always the risk of failed trials, adverse reactions to drugs and massive costs in research and development. Last week AstraZeneca halted its Covid-19 vaccine trial to investigate a bad reaction in one of its participants. The trial has now resumed, but it highlights the risks involved when dealing with people’s health.
AstraZeneca’s R&D department is world leading and advances in technology are helping it break down barriers. It’s pumping a lot of money into R&D, which stands to pay off handsomely if it results in ground-breaking medicines to tackle the world’s worst health problems.
So, are AstraZeneca shares worth buying? I think for the long term they probably are. I do think they’re expensive today, but risk aside, it’s an excellent company. If you really believe in a business and like everything it offers, I don’t think you should let its high price-to-earnings ratio put you off.
Kirsteen has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.