An investor friend has been eyeballing a 3D printing company, fascinated by the technology, and seeing big potential. But something’s holding him back: the price-to-earnings ratio.
“It’s too high,” he says.
We’re often victims of our own investing dogma. One of the most egregious articles of faith we follow is the insistence on certain metrics to back our bullishness. Example: A high-PE stock carries a bigger risk than one selling at a lower multiple.
Would investors have been better off buying Apple Inc. (NASDAQ:AAPL) at a P/E of 15 or 45? If you bought when Apple Inc. (NASDAQ:AAPL) was selling at a multiple of 45 in 2007, you could have ridden the stock to a 500% gain. Buying at the bargain-basement P/E of around 15 five years later could have earned you a 43% loss.
This underscores the value of a good qualitative argument as part of our investing decisions. While you can’t predict with certainty what a company will earn five years from now, you can build a pretty sound vision of how it will drive growth.
On that note, let’s take a look at three companies that get kicked around for having high multiples and see why investors are willing to pay up.
America’s favorite growth story
Amazon.com, Inc. (NASDAQ:AMZN) looks really expensive by almost any metric that accounts for earnings. Its forward price-to-earnings multiple is over 100. Still, even at sky high valuations, it’s returned 60% to investors over the past two years. Its 5-year estimated PEG is nearly 9.12. That’s stratospheric. Google Inc (NASDAQ:GOOG) sells at an estimated 5-year PEG of 1.37.
But investors are willing to overlook that valuation, and with good reason. Amazon.com, Inc. (NASDAQ:AMZN) has established such dominance that it’s becoming harder to see how it could not succeed in the long run.
It’s also continuing to stretch its tentacles into different areas, like cloud computing, and it’s doing so without borrowing money. It might be keeping narrow margins, but it’s using its cash flow to fund its own rapid growth. And then there’s this: Amazon.com, Inc. (NASDAQ:AMZN)’s new mobile advertising network is already reaping some $600 million in ad revenue. That’s another game-changer for the evolving company.
Where it could go wrong:
Amazon.com, Inc. (NASDAQ:AMZN) is building warehouses to get customers a wider variety of goods faster. Same-day delivery is in the offing, at least in some major U.S. markets. Those warehouses cost money, not just to build, but to operate. It’s hard to see how that won’t zap margins in the retail area, still Amazon’s bread and butter. Sales of merchandise make up 65% of overall revenue.
Amazon.com, Inc. (NASDAQ:AMZN) is a fast-evolving goliath. Bulls are willing to give founding CEO Jeff Bezos the benefit of the doubt that he’s figuring things out with the long game in mind.
The social media company that’s figured it out
You thought Amazon.com, Inc. (NASDAQ:AMZN) trades at a premium? It can’t hold a candle to LinkedIn Corp (NYSE:LNKD), which trades at an earnings multiple of — brace yourself — 662.20.
Astronomical? Yes. But LinkedIn Corp (NYSE:LNKD) has been a true anomaly among social media companies. By focusing on the professional needs of workers and companies, it’s figured out how to reliably make a profit, and it’s done so fairly early in its existence. (The social network launched its public profiles in 2006.) It’s been on a tear ever since it went public two years ago, giving courageous investors as much as a 266% return in short time. The most recent quarterly earnings swelled by some 76% over the previous year. While those numbers are impressive, they tell only a small part of the story. LinkedIn is still in its relative infancy.
The company has some 238 million members. Seems like a lot, but LinkedIn Corp (NYSE:LNKD) believes it has so far reached just 4% of its immediate potential market, which it estimates at $27 billion. What’s more, LinkedIn has already established international appeal. In fact, it has twice as many users outside the U.S. as it does in the states. That bodes well for continuous growth.
Where it could go wrong:
The landscape of social media changes with the weather. We’ve already seen many networks come and go, and the barriers to entry remain relatively low. It’s important that LinkedIn Corp (NYSE:LNKD) build on the advantages it’s established to gain a stronger hold on the market so it can weather the coming storms.