Many investors pay close attention to price-earnings ratios for clues on whether a stock is overvalued or undervalued.
But that approach doesn't work for growth stocks.
The P-E ratio is a common method of valuing stocks. It is computed by dividing a company's current share price by its earnings per share over the past 12 months. The higher the ratio, the more expensive the stock is considered. So, many value-focused investors shun stocks with a P-E ratio of, say, 20 or more .
But growth-stock investors should have no problem buying a stock with a P-E ratio of even 50 or higher, as long as it meets the criteria laid out in IBD's CAN SLIM investing system.
That's because IBD studies of the biggest market winners over the past 50 years show no correlation between their P-E ratios and their huge run-ups. In fact, many had high P-E ratios before starting their ascents.
For example, Google's (GOOG) P-E ratio was a whopping 133 when it broke out above a 113.58 buy point in September 2004, not long after it went public. The Internet search engine went on to quadruple by January 2006, to a high of 475.11.
"The fact is, investors with a bias against what they consider to be high P-Es will miss out on some of the greatest opportunities of this or any other time," wrote IBD Chairman and founder William J. O'Neil, in "How to Make Money in Stocks."
IBD research has found that strong fundamentals and a sound chart, not P-E ratios, are far more relevant in determining whether a stock will be successful.
Google's earnings roughly doubled every quarter for six straight quarters leading up to its September 2004 breakout, and revenue growth was similarly robust. The strong, sustained earnings growth was the reason why Google traded at such a high premium. As growth slowed, so did Google's P-E Ratio, which now stands at about 20.
"The reality is, the lowest P-E usually belongs to the company with the most ghastly earnings record," O'Neil wrote.
In some mature industries where there's little innovation and competition is intense, the result is low profit margins and weak earnings growth. You'd find some low P-E ratios in those companies.
To be sure, P-E ratios can come in handy for sophisticated value investors looking to find undervalued stocks. Such investors know that a low P-E ratio doesn't always mean a stock is cheap. Rather, it can be a sign the stock has little prospect for growth.
They also know that high-growth stocks can be risky. Stocks with a high P-E ratio must meet high expectations. A disappointing quarterly earnings report can send such stocks reeling.
That's why it's important to follow IBD's CAN SLIM rules when investing in high-growth stocks.