When a company trades on a high price earnings ratio such as REA Group Limited (ASX: REA) which currently has a price earnings ratio of 46, or even a nil price earnings ratio but large market capitalisation, such as XERO FPO NZ (ASX:XRO), as an investor how do you go about determining if the company represents value?
Growth companies often trade on large price earnings multiples because the market is forecasting that the company will make substantially higher profits at a future point in time. For example, Amazon.com, Inc's (NASDAQ: AMZN) net income for the period ended 31 December 2013 was US $274 million and it trades on a whopping price earnings ratio of 540. However, revenue in respect of the same period was a huge US $74 billion. The market is predicting that the company will improve operating margins through a reduction in investment expenditure, as well as further increasing its market share which will result in substantially higher profits in the future. Investors are required to pay a high price now to be rewarded for future earnings growth.
In determining whether companies trading on high price earnings ratios offer value, investors should look towards qualitative factors as opposed to quantitative measures. I believe investors should look at the following three measures:
- Does the company have a huge market opportunity?
- Does the company have a compelling and disruptive business model?; and
- Does the company have a strong management team?
In the case of REA Group, it is arguable that the high price earnings ratio is not justifiable on the basis that the Australian market is relatively small and mature. The company's business model is also susceptible to competition from other online competitors. However, it is arguable that Xero's high valuation is justified on the basis of its disruptive technology in the cloud computing space and its application to the accounting software market. Xero has the first mover advantage and huge opportunity to grow in the US and UK markets.
Investors should also look at the cash flow statement as opposed to the income statement to gain a greater understanding of the underlying performance of the business. The cash flow statement shows how much cash the business is generating which doesn't necessarily flow through to the income statement.
Foolish takeaway
Investors should not be put off by investing in companies with high price earnings ratios. Long-term investors should focus on the underlying business and the future growth potential of that business in determining value. Amazon is a perfect example of a company that despite trading on a huge price earnings ratio still appears undervalued at the current price.
