Why the P/E Ratio Might Be Useless

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Countless investors -- individuals and professionals alike -- spend their time seeking out cheap stocks.

A quick and easy way to find these is by searching for stocks with a low price-to-earnings ratio. This results in a slew of stocks with high P/E ratios being written off as expensive (meaning opportunities often lie hidden in this group).

The problem, though, is that a company with a high P/E ratio may not actually be expensive. A company with a P/E ratio of 50 -- or higher -- may be cheap. Which means...

For some companies, the P/E ratio is meaningless
It's a bold statement, but stick with me.

You see, the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history -- you're purchasing its future cash flows. What matters is what the company is going to do -- not what it has done.

This is important because there are a slew of companies whose P/E ratio may seem high, but their growth potential is so massive that buying them is still a bargain.

But what about the forward P/E ratio?
The forward P/E ratio (a company's market cap divided by its estimated coming-year's profit) may also be meaningless. That's because for many of these same companies, future earnings can't adequately be estimated. Many companies consistently blow short-term expectations out of the water -- so it's a fool's errand to estimate their growth over the long term.

To be fair, for some companies, the P/E ratio might be a telling sign that the stock could be a bargain. But for another category of companies, this metric is one you'd do well to ignore. What kind of companies am I talking about?

High-growth innovative companies that shake up the status quo
An easy example of such a company is Apple (NAS: AAPL) . Though its P/E ratio is currently just 16, this wasn't always the case.

In fact, during the first quarter of March 2003, Apple's P/E reached as high as 297. Yet had you bought shares of the company then, you'd be up over 7,300% today!

Apple achieved this remarkable success by continuing to innovate, bringing more and more products to market (the iPod, the iPhone, the iPad) that people didn't even realize they needed.

And although it's a $500 billion company today, its stock could still be a smart buy. If Apple continues to innovate and offer enticing products that consumers eagerly snap up, it could easily become a $1 trillion company -- or larger.

The same is true for Intuitive Surgical (NAS: ISRG) . Its P/E ratio ran as high as 299 during the last quarter of 2004. Yet had you bought shares then, you'd be up more than 1,600% today. A $10,000 investment would be worth over $170,000.

Intuitive Surgical came to market with an innovative medical machine that allowed doctors to perform minimally invasive surgeries on patients. It was a win-win proposition: It allowed more precision for the doctor, meant a quicker recovery time for patients, and less risk for both parties.

Its machines were expensive, but it didn't take long for Intuitive Surgical to convince the medical community of the merits of its device. Now it can continue to find new surgical uses for its machine -- or develop ancillary devices within its niche.

And that's why -- even trading for 42 times earnings today -- Intuitive Surgical could still be a smart investment.

These aren't the only companies that have been misjudged
In fact, there's a handful of companies I can think of that similarly fit the bill today.

VMware (NYS: VMW) is a leader in the emerging field of cloud computing. Sales have been growing at a warp-speed compounded annual growth rate of 40% over the past five years. Its P/E ratio is 64.

As cloud computing continues to grow, this early leader will own a dominant share of that market, meaning that even at this price it could still prove to be a bargain years from now.

American Tower (NYS: AMT) owns more than 39,000 cell phone towers throughout the world. Now classified as a REIT, it leases out space on its towers to cell phone network providers. Its P/E ratio is currently 64.

But as cell phones, tablets, and countless other devices continue to grow in prominence, bandwidth becomes more and more crucial -- meaning cell phone network providers will have to make their networks even stronger to handle the additional traffic. All of this is why American Tower's stock should be a bargain today.

Lastly, Amazon.com (NAS: AMZN) , the world's largest online retailer, has a P/E ratio of 134. On the face of it, this seems insanely high for a company with a market cap of more than $80 billion. Yet Amazon is furiously building out its empire -- both through acquisitions like Zappos and Diapers.com and through expanding its platform with devices like the Kindle. Not to mention, it also has a growing presence in the cloud computing niche, leasing out server space and offering virtual storage.

I think it's safe to say that the Amazon of the future will be vastly different than the Amazon of today -- and investors who get in today (even with its high P/E ratio) will be glad they bought shares when they did.

These aren't the only high-P/E stocks that would be smart to buy today
Motley Fool co-founder David Gardner has built his investing career largely around buying "overvalued" high-P/E stocks (including those I shared above) -- and with much success. In fact, his lifetime annualized return is a remarkable 19.6%, versus just 8.1% for the S&P 500.

David's about to launch a new venture called Supernova, in which he will share real-time buy and sell recommendations based upon his stoc ks -- so investors can mirror the trades in his real-money portfolio. To find out more about this exciting launch, simply type your email address in the box below. We'll tell you more about Supernova, and put you on the private invitation list for when we open its doors.

At the time this article was published Adam J. Wiedermanowns no shares of the companies mentioned above. The Motley Fool owns shares of Amazon.com and Apple. Motley Fool newsletter services have recommended buying shares of American Tower, Apple, Amazon.com, VMware, and Intuitive Surgical. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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