P/E ratio, or Price-to-Earnings ratio, is a commonly used valuation metric in the investing world. The P/E ratio tells you how much investors are willing to pay for one dollar of a company’s earnings and is calculated by dividing the stock price by its earnings per share (EPS). By simple logic, if a stock has a low P/E, then it’s cheap. The opposite is also true: if the P/E is high, the stock is expensive.
Simple. Logical. Foolproof. I mean, who wouldn’t love a metric like that? It’s a wonder it’s not used to value water, as the primary benefit of P/E over current alternative currencies (USD, CNY, etc.) is its universality. The logic behind the popularity of this number is sound, which is why many investors, especially new and inexperienced ones, use it as their main go-to tool for stock evaluation.
However, this logic falls apart when it comes to growth investing and, more specifically, to high-growth companies, which are our primary focus here at The Contrarian Investor. For value investors, the P/E ratio may be a useful metric. But, if you are interested in finding the next big winners among growth companies, or simply in improving your current growth investing results, then the truth is: the lower the P/E ratio, the less it may mean.
The Reason Behind the Obsession With P/E Ratio
In the world of investing, many different ratios have been developed and proposed to help us value companies. But none of them have ever enjoyed the same popularity as the P/E.
In part, this is because it checks a lot of boxes in terms of accessibility. First, the P/E ratio is easy to find. Every earnings release and fundamental analysis article and website shows it. Second, it’s easy to calculate: all you need is the earnings per share (EPS) and the stock price (obtainable from every Yahoo Finance page). Third, it’s forward-looking, in theory, and somewhat universal. If you can read a price tag, you can understand the P/E. Fourth and lastly, it tells you exactly what it claims to tell you: how many dollars are investors paying for one dollar of earnings.
In practice, however, this simplicity is mostly an illusion.
Growth vs. Value
The fundamental difference between growth and value investing is where you look when trying to value a company. Value investors typically focus on what a business has done. They look at the past, at past earnings, assets, or dividends. Growth investors are more focused on the potential of a business, on what it can become in the future.
On its own, a company’s trailing or even current earnings do not tell the full story of its growth. But that’s the problem with the P/E ratio: It is backward-looking and takes only those numbers as the basis for valuation. P/E doesn’t care about future growth; it is only concerned with how a company performed last year.
This is a fatal shortcoming for those who invest in high-growth companies.
Look at Amazon in the early 2000s. At the time, Amazon’s P/E was over 70. By all traditional metrics, it should have been avoided—it was too expensive. Instead, Amazon grew into its P/E, and then far beyond it, to become one of the best-performing companies in history. If you were looking at P/E ratios alone, you would have missed one of the greatest opportunities of our time.
There are countless more examples, both recent and historical: Tesla, Alibaba, Nvidia, MercadoLibre… The point is not that a high P/E is good. On the contrary, high P/E can often be a warning sign, and low P/E a big opportunity. The point is that when it comes to growth companies, the P/E ratio, by itself, should not be taken too seriously.
P/E Ratio Is a Misleading Metric
There are several reasons why the P/E ratio, used by itself, is often wrong.
First, it says almost nothing about the growth rate. A business that is growing its earnings at 50% per year is not worth the same as a business that is growing its earnings at 5% per year. P/E, by itself, cannot distinguish between a 5% growth company and a 50% growth company with the same earnings multiple.
Second, earnings themselves are a very problematic metric. They can be easily manipulated, distorted, or just temporarily depressed by a variety of accounting choices (stock-based compensation, write-offs, investments into future growth, etc.). As most companies reinvest heavily in the early years to drive growth, those earnings can look very unimpressive, or even negative, despite rapid top-line growth and a solid future.
Third, there are things like free cash flow (FCF). Some high-growth companies, particularly in tech, may show low or even negative net income but still produce plenty of free cash flow. A prime example here is Atlassian, which for many years after its IPO reported low GAAP earnings, while producing healthy FCFs due to its subscription model and high customer retention rates. A low or even negative P/E ratio in such a case tells you almost nothing about the strength of the underlying business.
Finally, and maybe most importantly, P/E tells you nothing about a company’s competitive advantage, or, more specifically, about those things that make a growth company worth buying. It does not take into account the power of a brand, network effects, switching costs, the strength of a moat, or even the size of a company’s total addressable market (TAM). These are exactly the things that investors often care about the most when investing in growth companies.
Bigger Picture
If you are a growth investor, then you have to take a wider view. Valuation, when it comes to high-growth companies, is more about future cash flows, about the total market, about a company’s execution capabilities, and about the scalability of its business model.
A single backward-looking earnings multiple simply does not contain enough information. Many growth investors use PEG ratio (price/earnings divided by expected earnings growth) instead, which corrects for growth and makes it possible to compare P/E ratios across companies with different growth rates.
Some growth investors focus on free cash flow and total return on invested capital (ROIC), which also gives a better sense of a business’ scalability and long-term value creation capabilities. Many others simply ignore P/E and instead look at revenue growth, R&D spend, customer acquisition costs, total addressable market, and other more future-looking metrics.
Some Examples of Growth Stocks With Very High P/Es
To better understand the above, let’s take a look at a few examples of successful growth companies and see how their P/E ratios look.
Nvidia, for instance, currently a dominant player in AI and high-performance computing (HPC), has historically traded at P/E above 60, and, many times, above 100. At such valuations, many traditional investors would call it overpriced and simply move on. But if you understand that Nvidia’s data center and AI businesses have been growing revenue by 30%+ per year, and, in some years, much higher, then a P/E ratio above 60 doesn’t look that unreasonable.
Tesla is another example of a company that has often traded at high P/Es. But its stock has been going up, not down, and many continue to see it as a high-growth business well worth the price. Is it expensive? Maybe. Is it overpriced? No one can say. The important thing to note is that if you look at P/E only, you risk entirely missing the potential of the company, both in terms of its end markets and in terms of its execution capabilities.
MercadoLibre, or the Amazon of Latin America, is another recent example of a growth stock with a very high P/E, which, at times, reached 100 or more. The market capitalization of the company was at one point larger than the GDP of Brazil or Argentina, the two largest economies in Latin America. But MercadoLibre is still growing at more than 50% per year, and its total addressable market, and TAM share, are still large.
The P/E Ratio and the Risk of Being “Cheap”
There is another, more sinister risk of focusing only on the P/E or any other backward-looking valuation metrics. The risk is that it can lead you to buy companies that are actually going to get worse, not better.
This is what is known as the “value trap.” Companies can seem “cheap” based on their P/E, but if they are in a declining industry, or their growth prospects are very limited, then their earnings, and their valuations, can continue to deteriorate. A low P/E, in other words, can be not a bargain but a trap.
This is particularly important for growth investors. If you are not looking at growth, or you don’t have a clear idea about the growth runway, then you are very likely to fall for the value trap. And that’s not good, because some of the best-performing companies over the past 20 years were companies like Amazon, Apple, Alphabet, Meta, or Nvidia, all of which often traded at very high P/Es, by traditional standards.
So if you are a growth investor, you need to unlearn the bias toward cheap P/Es. You need to be prepared to take a much longer view of a business and to think of valuation, not in terms of earnings, but in terms of growth. Growth investing is a different philosophy, with its own rationale and its own metrics. Growth investing is not about buying the past, it’s about betting on the future.
A Better Approach to Valuation
The alternative to focusing on P/E is not to dispense with valuation altogether. What growth investors need instead is a better, more sophisticated approach to valuation.
Instead of looking at one number, growth investors look at a wide range of data, from revenue growth rates to gross margins, and from customer acquisition costs to capital expenditures and capex coverage. The goal is to find an edge in pricing. When a company is able to scale sustainably, the market often misprices it. Investors need to understand what it’s worth, or at least make an educated guess, and then figure out where they have an advantage in pricing.
As Warren Buffett put it, valuation is not just about numbers, it’s also about feeling. Buying stocks is an act of courage and conviction. The highest returns come to those who are not afraid to hold highly-priced stocks, once they have done their due diligence and found the opportunity. That opportunity is unlikely to come from “cheap” stocks trading at low P/E ratios.
Conclusion
The P/E ratio is a good starting point. But for growth investors, it should only be a starting point. High-growth companies can often look very expensive when you use traditional valuation models. But that’s often exactly what their future growth justifies.
A high P/E ratio is not necessarily a sign that the stock is overpriced. A low P/E is not necessarily a sign of a bargain. The only way to know is to understand the reason behind the numbers.
The best investors, the ones who earn the highest returns, are the ones who do their research, and understand the story.
So dig deeper. Think forward, not backward. And don’t forget that the most rewarding investments are often the ones that are the most unreasonable, until they suddenly are not.
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