Don't Be Scared Away by a High P/E Ratio

A version of this article originally appeared in the July issue of Morningstar GrowthInvestor.

If there's one thing I'll talk about until I'm blue in the face, it's the importance of not overpaying for growth companies. Without question, this is the single biggest mistake investors make and a sure-fire way to get burned buying growth stocks. But for most individuals, determining when a stock is undervalued isn't easy. Most of the time, growth companies compete in markets that are always changing. Figuring out what a company will look like in a few years, let alone if a stock is cheap, can seem like an impossible task.

It's been my experience that most individuals deal with valuation in the context of the price/earnings ratio because it's a quick and easy way to calculate what a stock might be worth. We take a slightly different approach by valuing companies based on the sum of
their future cash flows, but we do pay attention to P/E ratios because they help us understand how "most investors" view companies.

The key is to figure out what you should and shouldn't pay up for. In my opinion, it's those companies with long-term growth opportunities and competitive advantages that are worth buying even if they aren't trading at rock-bottom prices. Typically, buying high quality at a fair price is more profitable than buying low quality at a cheap price. Unfortunately, it's this issue of quality that seems to escape most growth investors when it comes time to buy.

P/Es Don't Always Go Down
One of the classic mistakes investors make when trying to value growth companies is assuming that a stock's P/E will gradually revert toward the market or its industry average. There is little doubt that all P/Es eventually decline, but "eventually" can be a long time. For example, lots of the companies that we target at GrowthInvestor, Morningstar growth stock newsletter, have rarely traded at industry average P/Es.

 Expeditors (EXPD) is a perfect case study. The company has traded for around 35 times earnings for much of the last five years, well above the P/E of the market and its industry. It's been a consistent grower, so a premium P/E has been warranted. In 1999, the company earned $0.55 per share and traded for $21, which translates into a P/E of 38. Lots of investors could have easily looked at it then and thought its days of high growth were numbered. No company can outgrow its industry forever, right?

Let's assume that in 1999 you were able to accurately predict Expeditors would grow earnings 20% annually over the next five years to $1.41 per share. Most would assume a company couldn't keep up such a torrid pace for much longer. As a result, their thinking goes, the stock should eventually trade closer to its industry P/E of 18 at the end of the five years. Multiply a P/E of 18 by the $1.41 in earnings you would have expected and you would have arrived at a stock worth $25 in 2004--only slightly above where the shares traded in 1999. The only conclusion to draw would have been that the stock was overvalued. By overpaying, you would have stood by as the firm grew into its P/E.

This may sound sensible, but you'd be surprised how many people miss out on great investment opportunities valuing companies this way. The problem with this type of analysis is that it fails to consider the possibility that Expeditors could maintain a P/E of 35. The company has consistently grown at a high rate and generated huge economic profits through good times and bad, and its competitive position has never weakened. In that case, why shouldn't the stock continue to trade at a P/E of 35?

Expeditors has maintained its premium valuation. If you had believed that, then
you'd have made a lot of money. Multiply a P/E of 35 by the $1.41 in earnings you would have expected and you'd have gotten a $50 stock. It's no coincidence that's where the Expeditors traded at the end of 2004. The point is P/Es aren't always in a perpetual decline, particularly when you're dealing with high-quality growth companies. In fact, when a company's growth prospects improve, it's not uncommon for P/Es to expand. Sound crazy? It's not. As Expeditors has continued to grow earnings 20% over the past year, the P/E has actually expanded and the stock now trades in excess of $70.

Make the Most of Compounding
It's also important to take notice of compounding, a firm's ability to consistently grow earnings at a high rate by reinvesting earnings already in the door. For instance, if you grow earnings of $1 by 20% for five years, you'll earn $2.50. That's a 150% increase. If you grow another 20% for five years, you'll earn $6--a 500% increase. The beauty is that as the growth rates get bigger, the benefits get even better. 15% annual growth will double earnings in five years, 20% will double earnings in four years, and so on.

Why does this matter? Well, if a company maintains its P/E, its stock will at least increase with earnings growth. Again, go back to Expeditors. By sustaining a P/E of 35 and growing earnings 20% annually, Expeditors' stock price also increased 20% annually between 1999 and 2004. Compounding gets at why companies trading at high P/Es can still be attractive investments. Achieving 20%-plus growth on a consistent basis is easier said than done, but that's where quality comes in. It's not unreasonable to buy any company trading at a high P/E as long as it can consistently grow earnings and maintain its valuation. (My colleague Dreyfus Neenan recently explored this subject as well.)

 Whole Foods  has rarely traded below 30 times earnings over the last five years. On the surface, it's not surprising lots of people may have passed on a grocer with such a high P/E. But if you grasped the growth opportunity, the high P/E wouldn't have mattered. The key for Whole Foods has been continuing to grow at a high rate (earnings have increased 22% on average over the last five years) and to maintain its P/E. By doing that, the stock has paid off for any investor that paid up in recent years.

Over the years, lots of people have thought buying  Wild Oats , the smaller rival to Whole Foods, was a cheaper way to play the healthy food craze. That's exactly the type of behavior you should avoid. Wild Oats may have appeared cheap, but there were good reasons for that. The company hasn't generated a whole lot of earnings, so there hasn't been much to compound. While you might have done all right buying the stock at some point over the last five years, you'd have made a lot more owning Whole Foods.

Quality Over Price
I'm not suggesting you pay up for every decent growth company. What I'm saying is you can't look at valuation, particularly P/Es, in a vacuum. You first need to consider the quality of the business and then determine if the price is fair. That, in large part, will be explained by the company's growth opportunities and competitive strengths. Some of our most successful investments in the Growth portfolio, including  Blue Nile  and  Strayer (STRA), are companies we bought with high P/Es. In both cases, these were companies benefiting from widening moats and secular tailwinds that were trading for a fair price. We'd rather own companies like these than lower-quality names that trade at low multiples.