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Supercalifragilisticexpialidocious Part 2: Stocks with 100+ PEs

December 7, 2017

After writing the previous blog I thought of something that I do not understand and want to share that with you here. I just don’t understand the high prices of certain stocks with minimal or no profits. Specifically stocks with 100+ Price/Earnings (“PE”) ratios.

A company priced at 100, 200 or more times earnings might be justified as an investment because of its growth rate and potential for profits, but at some point there has to be a reckoning. In general, earnings or cash flow determines value for investment assets. There are some exceptions such as where there is synergy or a strategic reason for a buyer; where a buyer thinks that parts of the underlying assets are worth more than the whole and they think they have a way to monetize that; when there is a nonfinancial reason to invest such as ego, or to become a “player” in an industry, or perhaps to buy a job for yourself or a child; to enter or build up a geographic area; obtain critical mass; where there is hidden or undisclosed value; or a new value creation opportunity. Other reasons people invest and sometimes drive up prices is an emotional attachment to an industry, product, primary owner or founder or familiarity such as the preponderance of owners of Coke in Atlanta or former owners of Kodak in Rochester. There are many other reasons why people determine the value of a business, and they would all be valid except that they would not apply to stock market investors.

I believe the motive for nonprofessional investors (such as you and me) should be for dividends and stock price growth. A company’s sales growth for growth’s sake is not a viable strategy unless profits materialize; and then it is the profits that will drive the stock price. That is a simple statement of value. We had a dot.com bubble that burst in 2000; and a mortgage lending bubble that burst in 2008. Going back to 1637 there was Tulip Mania and in 1720 a South Seas bubble. There are many more and it seems with investing, history does repeat itself. It reincarnates and pops up every once in a while. I do not know if it is now with certain stocks, or when it will surface, but it will. Earnings drive value. Earnings drive value. Earnings drive value. Except when it doesn’t, but not for stock market investors. For stock market investors, earnings does drive value. On the short run, anything is possible; but for the long term, it is profits that will drive the value.

Let me use a simple illustration to explain how earnings drive value:

  • When a stock is selling for 100 times earnings, i.e. has a 100 PE, it means the earnings are 1% of the stock price.
  • If the market’s average PE is 20 then the average stock earns 5% of its market price.
  • Using this information it would appear that the 100 PE stock is priced 5 times greater than the average stock.
  • If accelerated growth along with profits occurs then then today’s price might be justified at some time in the future so the current investors would be giving up some future profits to own the stock now.
  • But suppose the growth doesn’t materialize or the growth in sales continues but does not translate into earnings, is it reasonable to assume the stock will keep increasing…or even remain at its current price? I think not. Even if the growth materializes, at some point there has to be a leveling off or normalization of that growth; and that, I believe, will be reflected in the stock price which will then be based on earnings, which to me indicates a stagnation of the stock price at best or an inevitable price decline.

I wrote about stock prices in 2012, 2014 and 2015 using Apple as the illustration and I believe my insights then still hold true. Stocks are something to invest in to get gains from the business’ growth and dividend payouts. Without earnings the stock price cannot keep increasing forever. Therefore, I don’t understand the high stock prices with 100 or more PEs, so will pass on them..

The Apple blogs were posted May 8, 2012, May 8, 2014 and Feb 17, 2015. They can be accessed in the archives on the right side of this blog site.

Enjoy!

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