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Question of the Day – Stock Valuation

By JLP | August 21, 2012

It’s been awhile since I posted a Question of the Day.

This question is related to the my last post comparing MasterCard’s valuation with Visa’s. Here’s the question:
Is there ever a time when a high P/E ratio is justified for a stock?

There are a couple of ways to look at P/E ratios. Take Visa, for example. It’s trading at around $128 per share and has a EPS of $1.01, giving it a P/E ratio of 127. In order for that P/E to come down to a much more reasonable 20, one of two things must happen (or a combination of the two things):

1. The EPS must come up to $6.41 per share and the stock price stay the same.

or…

2. The stock price must come down to $20.20 per share and the EPS stay the same.

or…

3. Some combination of the two.

Stocks get bid up high like this because investors are optimistic as to the company’s future prospects. Sometimes investors get too optimistic.

Personally, I would not buy a stock with high P/E ratio like this.

What about you?

Topics: Investing, Question of the Day | 7 Comments »


7 Responses to “Question of the Day – Stock Valuation”

  1. Stacey Says:
    August 21st, 2012 at 11:07 am

    If your question is about MC vs Visa…have no opinion about valuation, but was happy I had bought Visa over a year ago. I sold it before our vacation to lock in a gain…had no faith in the market’s valuations at that point. Now I wish I had it back…love a winner! :)

  2. JLP Says:
    August 21st, 2012 at 12:06 pm

    Sorry about that. I had a messed up link. Fixed now.

  3. Kirk Kinder Says:
    August 21st, 2012 at 12:47 pm

    A higher valuation can be justified if the company continually delivers, but anytime a P/E is over 100 you are playing with fire. No company has ever been able to keep that level of P/E…ever.

    History shows value outperforms growth over the longer term. So looking at valuations is critical.

  4. W at Off-Road Finance Says:
    August 21st, 2012 at 3:07 pm

    Usually high PEs are either growth oriented companies (tech, mostly) or survival plays – companies that may well fail, but if they survive will earn MUCH more than they are right now.

    Personally, I’m not a fan of investing in either of those classes. Even if your analysis was far better than random and you made good picks, the high volatility would force you into very small positions less you get stuck in a GRPN etc.

  5. clocks Says:
    August 21st, 2012 at 3:38 pm

    I prefer value investing. Everything I have read seems to indicate value stocks outperform growth stocks overtime.

  6. Ben Says:
    August 22nd, 2012 at 2:48 pm

    Value stocks outperform growth stocks because value stocks are riskier. So even though they outperform growth stocks over time they do so only because of the increased risk.

  7. Valkyrie Frost Says:
    August 22nd, 2012 at 4:43 pm

    I used to be a long term investor, but the past decade has proven that any gains I make in the market are lost to crises, then inflation and finally taxes.

    I’m now looking for ways to make investments that will not suffer such stagnation of losses. Any suggestions?

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