If you’re like many investors, you learned early on that one of the most important things to know about a stock’s value is the price-to-earnings (aka “P/E”) ratio.
I hate to be a party pooper, but if that’s how you were “brought up” as an investor – or if you only like to buy cheap stocks with low P/E ratios – you’ve been missing out on a lot of profitable growth opportunities.
The good news is that today I’m going to show you how to make a lot more in stocks than you’re making now. Here’s the story…
For generations, investors have used P/E ratios to determine if a stock is cheap and should be purchased or if it’s expensive and should be sold (or avoided).
Typically, stocks are considered bargains when they sell for P/E ratios of less than 12. Many people think a stock with a P/E of 25 is too expensive. (The long-term average P/E of the broad market is about 16.)
Now, I’m a bargain hunter in “normal” life. I’m always looking for deals when it comes to things like cars and real estate. However, decades of investing – and my studies of the greatest stock market winners in history – have taught me that a slavish devotion to low P/E stocks will cause you to miss out on pretty much every massive stock market winner of the next 100 years.
Put simply, a devotion to low P/E stocks will doom you to a life of under-performance.
Why is this the case?
Basically, you have to pay up to own the best, in both the stock market and in life. There’s a reason why Ferraris cost more than Hondas… and oceanfront property costs more than inland property.
Full disclosure: I’m a big fan of Ferraris, and even own a few of them, but I certainly don’t have anything against Hondas. But the reality is that Ferraris are in a whole different world than Hondas when it comes to quality and performance. That’s why Ferraris are more expensive than Hondas. The very best doesn’t come cheap.
This dynamic is at work in the stock market as well. The stocks of businesses with superior products, superior services, superior sales growth, and superior prospects outperform the stocks of lower-quality businesses. So, investors are willing to afford the higher stock market valuations of the best businesses.
My studies of the top stock performers of the past 100 years show that most mega stock winners trade for more than 25 times earnings during their huge runs.
What Really Matters When It Comes to Capturing Triple-Digit Returns
In my years of investing and studying the market’s all-time biggest winners, I’ve found that it’s much, much more important to focus on a stock’s earnings and sales growth than its P/E ratio. So much so that they are key factors in my proprietary stock grading system.
If you aren’t willing to buy stocks at more than 30 times earnings, you’ll automatically eliminate yourself from owning the world’s best growth stocks.
It’s not uncommon to see mega winners trade for 30, 40, and 50 times earnings during their mega runs. I’m talking about massive winners like Netflix (NFLX), Amazon (AMZN), Facebook (FB) and Google, now Alphabet (GOOGL).
I could list mega winner after mega winner after mega winner. But I’m sure you get the idea. You can’t buy a Ferrari for a Honda price. You can’t buy oceanfront real estate for an inland price. And you can’t buy the absolute best growth stocks at laggard valuations.
As winners like these soared hundreds of percent, many investors sat on the sidelines because they felt these stocks were too expensive given the P/E ratio. Those folks just didn’t understand that the very best doesn’t come cheap.
Now this doesn’t mean you should run out and buy any expensive stock. It’s important to keep in mind that a company with a fad product or service can get bid up to absolutely ridiculous valuations — and ultimately burn investors. You don’t want to get swept up in the hype and end up paying a ridiculous valuation that leaves you holding the bag in the end.
Tesla (TSLA) is a good example here. It’s got poor earnings and sales growth and is burning through cash. Those are clear signs that the company’s underlying fundamentals are weak, which could impact its long-term growth potential. And yet, the stock trades at over $200 per share.
All that said, the best investors know that top-shelf stocks often trade for seemingly-rich valuations of 30, 40, and 50 times earnings.
Earnings and sales growth are the major drivers of a stock’s price. The more a company grows its earnings, the more its shares will be worth.
That’s how the market works. It’s the “iron law” of the stock market.
And that’s why you should focus on the companies with massive revenue and earnings growth if you’re looking for stocks with massive upside potential, stocks that can bring you triple-digit returns.
Bottom line: High-quality stocks sporting high P/E ratios scare off the folks who are devoted to buying cheap, lower-quality business… but they reward those of us who understand market history… and know the very best doesn’t come cheap.