Why P/Es Matter When Buying Stocks

Google has a P/E (price to earnings) of 41.

Research in Motion (RIMM) has a P/E of 60.

MasterCard (MA) has a P/E of 29.

What do these stocks have in common? They are all expensive. But the shares have taken off and investors keep buying. The usual investor belief is that they’re “growing” so that growth justifies the expensive price.

But does it?

Mark Hulbert, a columnist with Marketwatch.com, had an interesting article the other day about Pfizer. You remember Pfizer- one of the largest drug companies in the world. If you bought Pfizer in 1990, you would have been very well off (i.e. “rich”) by 2000.

But after 2000? Not so much. In fact, the stock has been “dead” for the last 8 years. Even with a nearly 5% average dividend over this time period, all that the stock has done has gone down. In May 1998, PFE traded around $37. Today, it’s at $19.95.

Sales grew 250% over the past decade; far outpacing the growth rate of the overall stock market. Earnings per share also grew by about as much, as did sales.

With all that growth- why is the stock dead?

Because, as Hulbert points out, in 1998, the stock was trading at 51 times earnings. In other words- it’s P/E was 51- far higher than the stock has historically traded.

Pfizer’s P/E right now?

18.

Is it “cheap” now? Not really- but it’s getting there.

No company grows at over 20% for forever. Not even Google.

The point of Pfizer is that investors thought that the growth could save the stock and that it would trade at 50 times earnings for forever. No stock EVER does.

Starbucks has historically traded above 30 times earnings. This premium was paid mainly because investors believed in the “growth.”

Now- as growth appears to be slowing, the stock has been slammed. It’s P/E now? 18. And the stock continues to slide.

P/E does matter. Don’t think otherwise. While it shouldn’t be the only consideration you look at when investing- it definitely should be among the criteria you use when buying stock in a company. No company can keep up the hyper growth forever. Don’t overpay for your favorite company.