High PE Stocks: Fools Rush In Where Angels Fear To Tread!

  • Amazon has always followed a policy of growth with little thought to profitability.
  • Amazon has enjoyed logic defying P/E ratio.
  • An investor needs to look at underlying fundamentals. A high P/E ratio need not always be good.

Price to earnings ratio (or PE ratio) has been used by all well informed investors to quickly check if a stock is fairly priced compared to the company's ability to generate net profits. For the uninitiated, it is the ratio of current stock price and the company's net earnings per share (for last 12 months).

Historically average PE ratio for S&P500 companies has been around an average of 15. However there are some internet and e-commerce companies that enjoy gravity defying P/E ratios above 100 and sometimes even above 1000! How can one justify such a high pe ratio? Effectively what the investors are saying is that they are willing to pay 1000 $ for a stock which earns just 1$ profit every year. This is not even the dividend that the investor receives, it is just the net profit the company makes! Is it mass hysteria or is there some method to this seeming madness? Let’s examine the case of Amazon which has always enjoyed a high pe ratio. Amazon's PE ratio recently touched a record breaking high of 3000 mark in 2012 Q3.

High P/E Stocks: Amazon stock a case study!

Let us first compare the 5 year returns for Amazon versus its competitors, both online as well as in the brick and mortar space. The table below compares an investment of $1000 in Amazon (NASDAQ:AMZN) vs. eBay (NASDAQ:EBAY) vs. Walmart Stores (NYSE:WMT). We see that Amazons price has increased by 170%, eBay's price has increased by 53%, and Walmart’s price has increased by 43% only in the last 5 years.

Dec, 2007 Dec, 2011 Sep-28-2012(Crazy AMZN P/E) Dec, 2012 Now(as of Jun-06-2013)
Price P/E Price P/E Price P/E Price P/E Price P/E
AMZN 92.64 82.71 173.1 126.35 254.32 3633.14 250.87 NA 267.83 NA
EBAY 33.19 127.65 30.33 12.08 48.23 16.18 50.99 25.24 51.52 25.02
WMT 47.53 15.38 59.76 12.66 74.05 15.65 68.23 14.06 75.63 15.06

Amazon’s 5 years return has been 170%, eBay and Walmart returns stood at 53% and 43% respectively. However, for someone invested in Amazon a year back the returns have only been 45% compared to that of eBay which gave a return of 68%, whereas Walmart returns were -8%. Looks like eBay was a better choice a year back. Now how does one determine if the high PE ratio was justified?

Amazon’s P/E at all-time high, despite loss of $274M in 2012, Q3

The chart below shows a comparison of Amazon’s PE for the last 5 years compared with its online competitor eBay, and its biggest brick and mortar competitor Walmart Stores. Amazon has always enjoyed a high PE compared to its competitors eBay and Walmart. Amazon reported a loss of -274 million in 2012 Q3 despite generating a revenue of 13.8 billion, the same quarter during which its P/E had reached the crazy heights of 3000 levels. Amazon lost 37 cents a share, which is more than half of the total loss of 60 cents, as it had to “write off” its investment in the daily deals site “LivingSocial”. Even if we do not consider that quarter, Amazon has always enjoyed a high PE compared to its industry peers eBay and Walmart.

Amazon PE ratio comparison chart
Source: Amazon PE ratio chart by Amigobulls

Price to sales ratio: a better metric for Amazon

Since at its core Amazon is a “discount retailer”, in addition to the P/E ratio, we must also be looking at the price to sales ratio or P/S metric, as sales would be a better metric to base the stock price on. The chart below compares P/S for Amazon with eBay and Walmart Stores.
Amazon Price to Sales Ratio Chart
Source: Amazon price to sales chart by Amigobulls

Currently Amazon trades at a price to sales ratio of just under 2, whereas eBay has a PS ratio of around 5 and Walmart has P/S of 0.5. What we also see from the chart is that the PS ratio has constantly remained at a low level of 2 which is good news, as a low P/S with increase in stock price indicates an increase in sales which is good news for an investor.

Amazon’s sales have been $61.09 billion last year, compared to Walmart’s 469.16 billion. Walmart is thought to represent about 10 percent of total annual retail sales in the US, which means that Amazon is about 1 – 2% of the total retail sales in the US, and hence has a lot of growth ahead of it. However, if this growth does not translate into earnings, it is a point of concern, and for Amazon, the earnings have actually gone down in the last 2 years.

Lessons from history of high-growth, high PE stocks

Apple (NASDAQ:AAPL), which has seen phenomenal growth in the last 10 years, has grown its earnings from 140 million in 2003 to 41.73 billion in 2012, whereas for Amazon the earnings growth started with a loss of 35.22 million in 2003 to 632 million in 2011, and a loss of 39 million in 2012. Apple, considered to be at the heart of every innovation and technology never had a PE ratio above 50 (except in 2003 and 2004), and people who had put money in Apple made huge profits! Whereas for Amazon, investors have always paid more for every dollar of earnings. Why would one want to pay more for a company, which at its core is simply a retailer? Even if we take Amazons other offerings like AWS, only 3.4% of the total revenue came from AWS in 2012.

One needs to see the reasons behind the high PE of a stock. A very high P/E could be a dangerous signal if the same cannot be translated into profitability of the company. When a highly innovative company, with huge historical growth like Apple has been trading at a PE ratio of no more than 20 for the last 5 years, one needs to do a thorough check on the company’s financials and business before investing in high P/E, high risk stocks.

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Neither Amigobulls, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice. Buying and selling of securities carries the risk of monetary losses. Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions. Neither Amigobulls, nor the author have any business relationship with any of the companies covered in this post.

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Comments on this article and AMZN stock

Very well written article!
Hey, why should someone pay so much for just a retailer. All the growth story etc should have translated into real profits by now. When it is AMZN it seems profits are always in future and not today!
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Do share this awesome post