At which P/E ratio can a stock be considered overvalued?

Question

What's the "highest" P/E ratio that can be considered healthy? Sure, someone can argue that company X has growth potential, but even that is limited.

For example: Netflix has currently a P/E ratio of over 200 which gives me shivers.

Answer 1

It sounds like the asker is looking for a rule of thumb about P/E. If only the market would be so kind as to have a simple rule of thumb. It unfortunately depends on the time and the range you are looking at. For instance, looking at US Equities, from 2012-present, and looking at each PE value (i.e. thepe=2 finds all stocks with P/E between 2 and 3), we get the following:

That's a lot of lines! Looking at the backtest table, I can see that most of the lines with P/E under 10 underperform those with P/E over 10, and the really terrible lines are the ones with very low P/E values. So, lower isn't always better. But that wasn't the question! Are really high values bad? Using the same type of chart, going by 100's, we get our answer:

OK, we now know that the extremes don't seem to beat the market, and that it is better to be in the middle. Really high and really low P/E values signal trouble in this current market. Only two questions remain:

1. In the middle, is there an idea band of values? Yes, yes there is. We break the band of 10-300 into two bands: reasonable (10-100), and high (100-300), for easy visibility.
   Reasonable values go first (notice the "banding" as stocks sort into "value" stocks and "more expensive" stocks: High P/E stocks go next: These pictures tell us the trailing performance of portfolios of stocks having these P/E ranges. We can see that the high P/E stocks can go higher, but can also lose money over the whole timespan. The volatility is intense. The lower, but still reasonable, P/E stocks are a safer bet.

2. Does this hold true if we go back further than 2012? Is this an aberration of the current easy money policy, or some deep truth? We put the same two charts, just going back further, and see if it holds true: Notice the slope the lines have -- the sawtooth pattern with the lines on the left of each clump being taller indicates that lower P/E values were better. As the time scale gets shorter and shorter, the effect goes away, but that's hard to see. Hence the earlier pictures. Still, notice there are no money losing portfolios here. Now for high P/E values: Wow! That's some serious risk. See the lines that went down? Those are portfolios that lost money over the entire period! You can either make a killing, or get killed. It's a matter of luck, as you can see by the brown skyscraper surrounded by loss making portfolios on either side.

Finally, it is time for caveats and other brass tacks. These portfolios are US Equities, rebalanced quarterly, with data from Morningstar. Money losing companies are filtered out (they have no E for the P/E). This analysis does include delisted companies, and all returns include the effects of dividends and splits, with dividends being assumed to be reinvested into the companies. No trading costs or taxes were assessed on any the portfolios. The analysis was done using Equities Lab. I am a founder of Equities lab.

Answer 2

This is entirely subjective. A P/E of 200 is probably not sustainable in the long run but who's to say it is unhealthy? Others might not see the metric as so ludicrous. We have seen a record number of share buybacks since the GFC (Global Financial Crisis of 2007-2008), so that's probably contributory (as corporate governance and stakeholder theory in the U.S. incentivizes management to buy back shares) to such high P/E ratios across blue chip stocks. But that is only one small factor.

Investors also put more weight on other valuation metrics like EV/EBIDTA, FCF yield, the list goes on. I'm not discounting the importance of P/E ratios in fundamental analysis, but some people value other metrics more.

Edit: Tangentially related (because P/S ratio), but it would be remiss of me to leave out a quote from Scott McNealy (former CEO of Sun Microsystems) after the dot com bubble burst.

But two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?

-Bloomberg, 2002

Answer 3

So the argument for these ultra high P/E companies is that at some point they can simply slow their rate of reinvestment and the net earnings will dramatically increase as a result. At some point Netflix won't need to pile resources in to saturating the new content market. At some point Amazon won't need to deploy new datacenters or delivery trucks or whatever. I don't necessarily buy this argument, though the logic is pretty sound, and 3 digit P/Es are a major turn off for me. 50 is sort of where I draw the line in my individual trading account, though that's admittedly largely arbitrary...

Chipotle is a pretty good example of extreme growth projections, and an ultra high P/E, snapping back toward reality when there's some friction.

Answer 4

A P/E ratio of 10 to 15 is about what a steady sized company should have.

That said, a company can still be overvalued at 10. Perhaps the company is not only not growing but shrinking. Its current revenues are the best that it will ever have.

A P/E ratio of 200 is high. But it is basically saying that people expect the company to grow earnings to be 15 to 20 times as large as they are now (so the P/E ratio would be 10 to 15). If you don't think that the company has that kind of potential, don't invest.

Really, a P/E ratio for a growth stock is probably the wrong measure. Because it is possible for earnings to be exceptionally small or even negative in the short term. But the stock may have an upside.

A P/E ratio is more useful when evaluating a value stock. Because the value stock does not have the same anticipation of an increase in future earnings. So examining past earnings (which is what is in a P/E ratio), they are likely to be more predictive.

How can the price-to-earnings ratio mislead investors?

Just as a quick note, AMZN has more than quadrupled in price since that article was written and is now over $1500 per share. APPL has not quite doubled. Anyway, AMZN may be overvalued. But if someone had avoided it in 2014 in favor of the more reasonably priced APPL, they would have only had half as much growth.

Answer 5

Simply said, PE ratio represent time required for investor to obtain their full investment back. It means that Netflix with PE 200 has 200 years needed to pay your investment, and I don't think It's price attractive enough.

Ideal PE should be below 15, but always there are some exceptions. Company with strong and wide moat with high CAGR can accelerate their earning thus shorten payback period is good investment.

netflix CAGR revenue around 27%, which is very outstanding compared to whole company in US (may be even in the world), market allows this wonderful business to have premium valuation. In my calculation, normal PE for Netflix is around 75 (PE 15 doesn't apply here)

conclusion: pay attention to its brand, moat, business, industry, strategy, and examine their financial performance like ROE, CAGR, retained earning.

Answer 6

Historically a P/E ratio of 24 or more is considered overpriced, but as others have mentioned, it is subjective. Many in finance use price to sales, price to book, liquidation value, enterprise value or other methods to determine a reasonable price to buy a stock, and whether or not it is overvalued relative to its price. P/E is relatively subjective, but the rule of thumb is around 20-24 is expensive from most finance books/ research that I have looked at.

Answer 7

It depends on how much growth you can expect the company to have. Low-PE companies should be the ones with little potential upside. A public company could be losing money. Then the earnings are negative. But if it has a potential to significantly grow its market and realize economies of scale at a larger size, then its anticipated future earnings justify the price.

Answer 8

The P/E ratio is the ratio of the price today divided by the earnings today. This number can be very meaningless. Say the company has a single product that everyone know is on its way out. They are making money today, everyone knows they will make less money next year, and they won't make anything the year after. A P/E ratio of 10 would be overpriced, because we know the company's earnings will never be 10 times today's price.

Or you have a company in a very stable business. For the last 50 years, they made the same money every year, with no reason why that would change. A P/E ratio of 10 is the same as giving the company a loan with 10% interest, P/E ratio of 20 is the same as giving a loan with 5% interest.

And then you have companies who just start building up their business. Any penny they make gets invested immediately to increase the business. A business that makes 10 million and invests it immediately, making no profit, is as good as another business that makes 10 million and gives it to the shareholders. The first business can have a huge P/E ratio, and the actual ratio doesn't even matter (whether they reinvest 9.5 million or 9.9 million or 10.1 million makes little difference to the value, but a massive difference to the P/E ratio).

So you need to find out which category the business is in, or what amount of earnings you expect in the long term.

Answer 9

In general, the standard rule of thumb is that a PER over 24 is considered overpriced. As others have stated, however, many other mitigating/ exacerbating factors can be in play here, so don’t arbitrarily apply this standard to all stocks. Instead do some research before making an investment decision.