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All It's Cracked Up to P/E?

The P/E ratio is one of the most commonly used metrics that investors when deciding whether to invest in a company.

In this week's tech edition of Industry Focus, analysts Dylan Lewis and Simon Erickson explain what a P/E ratio measures, what it implies about a company, and how the Motley Fool Rule Breakers crew looks at it differently than the majority of the market does. The hosts take a look at two companies that have proven the merits of the Rule Breaker method when it comes to P/E ratios, and one company Simon sees as potentially fitting into this pattern today.

A full transcript follows the video.

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This podcast was recorded on June 3, 2016. 

Dylan Lewis: This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans. Rocket Mortgage brings the mortgage process into the 21st century with a fast, easy, and completely online process. Check out Rocket Mortgage today at QuickenLoans.com/fool.

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 3, and we're talking tech and P/E ratios. I'm your host, Dylan Lewis, and I'm joined in studio by Motley Fool premium analyst, Simon Erickson. Simon, how's it going?

Simon Erickson: Pretty good. Thanks for having me, Dylan.

Lewis: It's great to have you. You said before we did the show this is the first time that you've been on Industry Focus.

Erickson: I believe it is.

Lewis: I find that hard to believe because you are so...Every time I see you walking around the office you're coming back from like a Supernova shoot or doing some video work here. You're on a couple different premium products, right?

Erickson: That's right. I work on the Supernova Explorer missions and also for the Million Dollar Portfolio. Really glad to be here.

Lewis: For your own kind of investing background, you are a very tech-focused guy. Right? You're kind of that Rule Breaker mind-set that we have here at the Fool.

Erickson: When we say Rule Breaker, we're looking for innovative companies. Companies that invest in themselves to go after the growth for tomorrow. Makes up the majority of our Supernova portfolios and a good chunk of the MDP, the Million Dollar Portfolio as well.

Lewis: It's a fun, fun space to follow.

Erickson: Yes, indeed.

Lewis: Today's show we're going to do a little bit of a rundown on the P/E ratio. Exactly what it means, what it implies, and how some Fools, Simon and a lot of the people he works with, use it a little bit differently than most investors. Just as a reminder, the P/E ratio is our price-to-earnings ratio. This measures a company's current share price against how much it actually earns in per-share income.

There's typically two different ways you're going to see this broken down. Either TTM, which is trailing 12 months, and so that's looking back at what the company has actually posted in earnings, and then on a forward basis. That's taking analyst's estimates of earnings expectations and then applying it to the current share price. Do you put more merit in one or the other, Simon?

Erickson: I mean the estimates are just estimates, right?

Lewis: Yeah.

Erickson: This is typically a consensus estimate of what a lot of analysts think the company is going to do in the future. It may or may not look like that but the trailing 12 months is what they actually did do so I guess that's the biggest differentiator between past and forward.

Lewis: If you see a company with a lower forward P/E it should be because the company should be growing?

Erickson: Hopefully, yes.

Lewis: That's what you want to be seeing. If it's higher, then the company is probably not doing so great.

Erickson: Yeah, exactly.

Lewis: Just an example of how this works, Apple (NASDAQ: AAPL) currently trades for just under a $100. It has trailing-12-month earnings of just like $9 per share, roughly. That gets you a P/E, a trailing P/E, of almost 11. Forward P/E, it depends on the estimates you use. You'll see that number fluctuate quite a bit. For Apple, most forward P/E estimates fall in the 10 to 12 range. P/E is often cited as this very quick, at-a-glance for a company's valuation. It's a number you can kind of wrap your head around very easily but on its own, at least in my opinion, it's kind of meaningless. I don't know what your thoughts are there but to me it's all about putting it up against peers or against the broader market itself.

Erickson: Yeah, that's right. It's probably the most common traditional metric for valuation of looking at stocks. Just OK, "What's the P/E ratio?" To kind of give you a general feel for how expensive a stock is or how inexpensive. The reason we say that is because basically the price, the numerator, is the market cap divided by the trailing or the forward earning and you got to think of that top one as the market cap is just a function of what the market is willing to pay in relation to $1 of forward or of trailing earnings. That's why we say expensive or inexpensive. It's basically a higher P/E is a company is being rewarded with a higher market cap per dollar of earnings which is kind of representative of what the market thinks of them.

Lewis: I largely think of P/E as a signal of growth expectations and that kind of plays into what investors are willing to pay now. It's really what does the market expect from this company. You look at your high P/E companies, market's basically saying, "We expect this company to be making a lot more company in the future and we're willing to pay up for it now to enjoy that ride, that share price appreciation that comes along with it." Low P/E companies, the market is saying, "We don't really expect a ton of growth from your business. We don't expect it to outpace your competitors or the broader market." I think actually, right now, Apple is kind of a good example of that. You look at them, their trailing basis, like I said, around 10 or 11. The broader market is in the low 20s. You look at some of their competitors, like Microsoft, they're actually up in the low 40s right now. That disconnect in valuation is the market signaling we don't expect Apple's growth to outpace the broader market's growth rate.

Erickson: Yeah, a great point you pointed out. What point of the life cycle of this company are we in right now? Are we a super-fast growing, early stage company that should be plowing most of its money into the company itself to grow faster, or we are an established company that's been around for decades and everybody is using its products and it's pretty stable growth? Not remarkable growth but you want to be paying out more of those earnings in forms of dividends or stock buybacks rather than plowing them right back into the business to go after more growth.

Lewis: Yeah, and the idea there is if you're reinvesting it in yourself, the ability to grow the business and the growth rates you'll achieve by investing that money in is better than what you'd be giving shareholders via a dividend.

Erickson: Exactly.

Lewis: One of the reasons I wanted to bring you on the show is the Rule Breaker way, and some of the ways that our premium analysts think about P/E, is quite a bit different than how a lot of people think about P/E, so you'll read articles and they'll say, "This company is a P/E of 40 and they're really overpriced. They're very expensive right now." That's not really the way that you guys think about it, right?

Erickson: Yeah, that's right. A lot of it is a function [of] where the company is but also where the market is, too. If you got a mature market, you would expect maybe a higher earnings out of the company right now. It's more mature -- but if it's a new, fast-growing market, maybe you're willing to pay more for future growth out of that company.

Lewis: Some investors will categorically rule out these high-P/E companies. They're not interested in paying out for speculative growth. They're going to take your stable, low-P/E dividend payers, people that are buying tons of shares. Stuff like that. I'm going to reference an old fool.com article here. It's one from 2006. The headline is "The Highest Possible Returns." This is one David Gardner wrote a little while back. He lays out his methodology for stock selection.

I think this really great note here that kind of hammers home how some people here at the Fool think about P/Es and just general valuation is sign No. 6 and I think this is a maybe a 7-step kind of approach for looking at Rule Breaker or companies that will outperform. You must find documented proof that [the company] is overvalued according to the financial media.

The quote that he writes here is, "If a company is growing its earnings and as a result has an increasing valuation, there will be someone somewhere that will argue that the company is overvalued. The reason this is valuable is that it keeps people out of the stock. Later on, as a company proves out its position and is profitable, even dominate later as a market leader, then the skeptics will finally buy in." It seems like that's kind of the approach internally and that's the mind-set with which you're looking at some of these companies that maybe a lot of people are overlooking.

Erickson: That's exactly right. As you point out, we have six signs of a Rule Breaker. This is kind of our philosophy for investing in growth and this is our final sign. Sign 6 is that it is overvalued. As you pointed out, Dylan, a lot of investors -- which this is not a bad thing -- but just will not invest in higher-P/E companies. They want something more stable. They want to buy tobacco companies or Coca-Cola kind of companies to just have that steady, recurring dividend stream you can count on. If you're in retirement, there's nothing wrong with that. You want that steady income coming through, but growth investing doesn't do that.

We really are looking for companies that are taking that stream of gross profit and then operating profit, which is after you pay back your R&D, your operational costs, and you're reinvesting that right back into the business. We want the companies that are going after the growth tomorrow. There's a lot more uncertainty from that too, right? You don't know if it's going to work so you have to look at softer factors like what does the management team look like, what is the vision of the CEO of this company, what is the board of directors comprised of. Those are things that are not as quantitative that you can just look at in ratios and really discern out a P/E ratio. A lot of companies that stuff really matters for stock returns. We're going to talk about a couple of those later on the show here.

Lewis: Yeah, I think one of the other points to bring up with very high P/E companies is they tend to be in nascent markets so it's one that is much harder to predict the total value of that business and the market share they're going to be able to realize and just the value of that addressable market. Even if you do have a perfect understanding of that because it's nascent, a lot of people just don't understand it. It's hard to see exactly where it's going to be five or 10 years from now, whereas your big tobacco companies, your soda companies, things like that -- people have a general sense of what demand is going to look like and what the big picture is for them, right?

Erickson: Absolutely. I mean look at Facebook (NASDAQ: FB); it's a perfect example of that. A couple of years ago, Mark Zuckerberg says he's going to be paying $2 billion in an acquisition of Oculus for virtual reality. I remember seeing a lot of headlines that were laughing at this move, right? What is thinking? Virtual reality? We've been talking about that for three decades. No one has ever done anything with this. Now we went to the South By Southwest Conference earlier this year. Right, Dylan?

Lewis: It was a blast.

Erickson: What was one of the biggest topics at this South By Southwest conference?

Lewis: Virtual reality.

Erickson: I mean it's amazing how just in a couple of years this has gone from "What are we thinking?" to "This is a really big deal that everyone getting excited about and behind." That just shows you when you're early on in developing a new market and you're a visionary leader, you can gain a lot of reward in a lot of places that other companies are not looking at.

Lewis: We're going to take a quick break. We're going to come back. We're going to talk about a couple of examples from the past from the Rule Breaker and Fool universe of some high-P/E companies that have kept soaring. We're also going to take a look at one that Simon currently has his eye on right now.

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Simon, this being the tech show, we cover [an] industry with a lot of high-flying P/Es. I thought it would be really awesome to talk about a couple of companies in this space that have illustrated some of the merits of this approach. Looking at these high-P/E companies that have done pretty well for investors and then maybe talk about one that you're particularly excited about now that's maybe a little bit under the radar.

Erickson: Great.

Lewis: I wanted to bring you on the show because I know you focus on tech and I think that this space is particular prime for this type of investing approach. You have a couple of reasons for that.

Erickson: Sure. Again, when we're talking about the E in the P/E Ratio, this doesn't account for a lot of things that a lot of tech companies are plowing back into the business which is decreasing the E which is inflating the P/E ratio. If I haven't confused everyone with that analogy there.

Lewis: There's a lot of rhyming and letters going on there.

Erickson: It's companies that are investing more in themselves. The first reason for that is really kind of cloud-based computing. Companies are spending very heavily on servers and a lot of IT infrastructure for hosting things in the cloud. More and more software is moving this way. When you spend a lot of money upfront on those servers and infrastructure, you have to depreciate that over time. Depreciation reduces your earnings over time, too, so you have less reported earnings in the short term but a huge benefit over the longer term.

The second thing we've really seen in the tech industry also is there's kind of a favor of or preference of paying employees, especially developers, in stock. Stock-based compensation is an expense which is not a cash expense. A lot of these companies are still producing a lot of cash flow but it does work against your earnings, too. Companies that pay their employees in stock rather than in cash, that tends to be a lower P/E, I'm sorry, a higher-P/E, lower-earnings company that's still pulling in a lot of cash from licenses. Two things that particularly pertain to the tech industry for this.

Lewis: Got you. Let's look at a few examples here. Two from the past that you wanted to highlight. Amazon (NASDAQ: AMZN), a Fool favorite, and salesforce (NYSE: CRM). Why don't we start off with Amazon? Not a company that was profitable when David Gardner originally recommended it back in 2002. Their top line has grown 25 [times] since then which is incredible. It seems like it's moving toward constant profitability. What do you have to say there?

Erickson: What's the P/E today of Amazon? Do we have that number?

Lewis: It's in the 100s.

Erickson: Okay. It's still in the 100s even though the company has been around for more than 20 years now. Jeff Bezos premium. This is a company that at first didn't get a lot of attention because they thought they were just spending too much money on the infrastructure to build out this new e-commerce thing. Then when you start seeing them gaining share and people keep coming back and back to Amazon over time, that's a different story today. Amazon is still, as you said, 25x increase in revenue trading at astronomical P/Es but no one's looking as much at that P/E ratio because there is a lot of faith in Jeff Bezos and the future of Amazon so one example right there.

Lewis: Salesforce [is] actually really not all that different. They weren't profitable when they were originally picked and despite a massive run up over the last couple of years, they're still not profitable. I think you're seeing them realize market share and a lot of the big expectations that are built into the stock but it seems like the valuations for both these companies suggest there's a huge runway in front of them.

Erickson: That's right and when we say not profitable, we should specify this is not GAAP earnings profitable.

Lewis: Correct.

Erickson: We're reporting a negative net income even though Salesforce for years has had positive operating cash flow which is something else we look at a lot in Rule Breakers and Supernova. If you're paying out stock-based comp, if you're depreciating the equipment, those are non-cash charges. We also look at the operating cash flow and how much is actually going into the company's bank to pay for things like servers or infrastructure and stuff like that. They've been very profitable by that metric for a number of years.

Also a very visionary company, I would argue, with Salesforce. They kind of redefined software, especially customer relationship management which is their kind of specialty in putting it into the cloud. It's no longer going site by site and selling bulky software to companies. It is centrally hosted over the cloud and that requires a lot of investment up front but it's also a lot easier for the companies that you're selling to. It's gotten them a lot of wins over several decades now.

Lewis: P/E can be kind of difficult for some of these companies. Particularly ones that don't have any GAAP incomes to report. Right? You talked about some other metrics that you can look to for success. What do you think about price of sales for these companies?

Erickson: It's a good one for a tech but it's early on. Again, you wouldn't expect. There are very few companies in the tech industry that right when they're incorporated are immediately profitable. It just doesn't happen. They're plowing it into the business for reasons we talked about. Maybe a more appropriate metric for companies like that, that aren't profitable, is the price-to-sales metric. You can see the growth of the company at the top line and how valuable is that to investors when you're looking at the market.

Lewis: At least with that you kind of have something to hang your hat on as with a negative P/E ratio you're just like...you don't know what to do with it, right?

Erickson: Exactly.

Lewis: Last one you wanted to hit on here, Veeva Systems (NYSE: VEEV). This is something you're really interested in now. I know they're in the cloud space. What exactly do they do?

Erickson: Sure. Veeva Systems to start with why this company exists. This was founded by a gentleman named Peter Gassner. He came from Salesforce.com. He was the vice president of technology at Salesforce. He built out all of that back-end architecture that no one knows what's going on back there for Salesforce. All the servers, all the infrastructure, all of that stuff that keep that software running. He designed it and he built it.

He made an agreement with Salesforce that he was going to go after customers in the life sciences markets, so healthcare companies, pharmaceutical companies, companies selling drugs to hospitals. The reason that's interesting is because traditional sales, traditional customer relations management is you want to be more efficient with your sales force. Before I was an investor, I was actually a sales guy myself. We'd go out. We would do calls. We would write up a call report. We would distribute that to the company and then we'd try to make sense of what was going on out there.

CRM software allows you to immediately in the cloud, throw that all up there, see where your wins are, see where your profit margins are and see what customers you should go after. Gassner said, "Hey, there's a great opportunity for this in life sciences, too. You want to see what drugs are hitting well. Which are your blockbusters? Where should you be directing your sales force?" He brought CRM to the life sciences industry and that's what Veeva Systems is doing.

On top of that, they're also now working with pharmaceutical development. The R&D part of that is also very important for your pharmaceutical company. You want to develop drugs more efficiently. Get through these FDA trials more quickly and that can reduce your cost so when you do commercialize the drug, you get a better bang for your buck. That's what Veeva Systems does in a nutshell.

Lewis: This is something we saw quite a bit of when we were at South By Southwest, these tech companies, traditionally tech companies -- or what they do being more in the tech space -- kind of creeping into these other industries and I think this is a perfect example of something like that.

Erickson: Yes, absolutely. Life sciences is more and more data-driven. You're seeing like you talk about South By Southwest, there's more and more decisions being made based on data rather than, "I've got a hunch," or "This is what the past has told me." A lot of that is because you're able to see into the human genome now. You're able to see DNA-level data that can direct decisions that actually improve outcomes which is quite fascinating. That you're improving patients' lives from all of this too. Really hot space right now.

Lewis: Still a very nascent one, right? As the P/E suggests, it kind of backs it up. I think they're currently in the 80s so that certainly fits the bill for pricey companies.

Erickson: If you look at that -- if I can jump on that, too -- traditionally it's been CRM software like we were talking about but Vault, Veeva Vault, is now addressing that R&D side of the equation and they also just said, "Hey, we're applying this for highly regulated market that is like sciences, why don't we expand our reach to outside of life sciences, too?" On the last conference call, Gassner said, "Hey, we're going to expand outside of life sciences. There's a lot of regulated industries that want to be more efficient. Veeva software proved that it works for pharmaceutical companies. Let's see where that would catch on somewhere else." You've seen the stock price of Veeva jump about, from the chart I'm looking at, about 75% since February because you can start seeing them unlocking value in those nascent markets like you mentioned. Huge opportunities. P/E still skyrocketing high but the market is understanding the value of what this business is bringing.

Lewis: Yeah and that's really where a lot of these astronomical P/Es come in. You have companies in spaces that maybe don't even exist. A lot of the stuff that Amazon is currently doing, a lot of people probably wouldn't have conceived of five years ago. You look at what they kind of unveiled with their web services division and how incredibly profitable it is for them. That wasn't something people really had a sense of until they started disclosing the financials there. Part of the reason you see these high P/Es is just people don't exactly know where business is going or what's under the hood sometimes.

Erickson: Perfect example, like you just said. Businesses learn what they're good at over time and can expand their market. Another one that I'll bring up is Uber. Private company. Not traded on the stock market unfortunately for publicly facing companies or publicly traded companies rather. This is a company that started as a ride-sharing app in New York City. Right? Black cars in New York City would pick you up and they realized they were an app company, and not a car company, and they started expanding that.

They said, "Hey, why don't we open this to more cities? Why don't we expand this to logistics, transportation rather than just ride-sharing and stuff like this?" Now Uber is, you know, [valued at] several tens of billions of dollars of market capitalization right now. It's a company that learnt where its niche was, learned what it was good at, and expanded those markets. A lot of that you'll see always at a high P/E ratio and definitely a Rule Breaker kind of company.

Lewis: If you're thinking about a company and what they're currently doing, the P/E Ratio, if it's high, is never going to make sense.

Erickson: Exactly.

Lewis: Right? It's much more about what they could be doing and that's what you kind of have to pay attention to. If you see that the things that management is talking about or the opportunities that are available to a company in that kind of space can justify those types of valuations, then it might be a company worth looking into. I think that's generally the way to think about some of these high-P/E tech companies.

Erickson: Absolutely.

Lewis: Anything else, Simon?

Erickson: No that's it. Check out our Rule Breakers website if you want to learn more about high-P/E-growth-y kind of companies. We do have the six signs of a Rule Breaker. You mentioned one of them that it's kind of historically overvalued in the media. You want to find the right companies to do that, too. You don't want to just go out and say, "Hey I'm going to buy every high-P/E-ratio company out there." The devil is in the details of that. You have to really say but why is the P/E high on this, what is the future going to look like for this company. We kind of try to spend a lot of our time identifying those competitive advantages and why this company is different than anything else that's unprofitable out there. That's the trick of Rule Breaker investing.

Lewis: To your point earlier, these high-growth companies, the high-P/E companies, they're not necessarily for everyone. Depending on where you are in your investing life, it might not make as much sense but it's just something to think about and consider for your own portfolio.

Erickson: That's right.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out and say hey, shoot us an email at industryfocus@fool.com or tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Simon Erickson, I'm Dylan Lewis. Thanks for listening and Fool on!