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No new tech stock picks today, my 7 current trades are all filled up. Instead, I wanted to tackle one of the questions that I get over and over. Here is one example but there are several more: “How about P/E ratio? I was always under the impression 18 was the limit. Then my broker told me not for utility stock it is lower – 14. Another article recently “Don’t Be Afriad of High P/E’s”

As I’ve said several times already, P/E ratio is one of the things that I pay the most attention to when I invest in stocks. It’s not a perfect metric by any means. There are cases where the number doesn’t work such as companies that are losing money or if a company had non-recurring items such as AOL’s patent sale which can “screw up” the earnings and thus the P/E ratio. That being said, it’s probably what I use the most when I feel like the number is reliable. Why? Because it gives me a comparable metric to use between stocks.

There Is No “Good” P/E

I do understand why some investors stay away from high P/E ratios such as Amazon. Those companies typically carry more risk. There is a reason though why investors are willing to pay a higher P/E.

It’s All About Growth

I typically look at growth in sales/revenues and earnings. The reason of course is that you typically will pay more for a company that can grow faster. Why? Let’s imagine a company named Microsoft (MSFT) which currently trades at a P/E of 18 and Google which trades at a P/E of 26. To make things easier, let’s imagine they both made $1 of earnings.

So Microsoft would be trading at $18 and Google at $26. Which one would you prefer buying? Clearly, Microsoft is cheaper to buy for the same earnings. But what if Microsoft is growing at 10% while Google is growing at 20%… ?

One year from now. Microsoft would be making $1.10 and Google $1.20. Suddenly, the “forward P/E” for Microsoft would be 21.7 and Google 16.4. much closer right? If you keep the same growth for 3 more years and they’d be trading at basically the same “forward P/E”. So if I anticipate Google can keep up that growth advantage for 4 years, I’ll go for Google without a doubt.

Every time I do such a trade, I try to look at past growth and make projections as well as evaluate the probability that growth will keep up, accelerate or decline.

There Is No Answer

I could not tell you if I prefer high P/E ratio stocks or lower ones. It all depends on the level of growth I expect in the future. I’d recommend that you do the same. Many try to use the PEG ratio or P/E ratio to growth which can work. I prefer to do my own analysis because the growth used in the PEG ratio is also very easy to debate.

Do You Use The P/E Ratio? If so, how do you compare different P/E ratios?