Companies that trade on a high price-to-earnings ratio are usually classified as ‘growth’ stocks. In other words, they are expected to grow earnings at high rates over the next few years, to compensate for their current high P/E ratio (or high price).
To give you an example, a company may trade on a P/E ratio of 30 or more, which looks expensive compared the market’s forward multiple of around 14 times earnings. But a P/E ratio of 30 may well be cheap, if a company is consistently able to grow earnings above 20-30% (as you’ll see in some of the examples below).
Job ads and training company Seek Limited (ASX: SEK) currently trades on a prospective forecast P/E ratio of 34, but has grown earnings per share at 30% each year over the past five years! No wonder its share price has gone from under $3 to over $17 in that time. If Seek can continue to grow at 30% annually over the next five years, today’s price is cheap. The problem is, if Seek can’t, investors are likely to savage the company and the shares have a long way to fall. I’m a believer in Seek, and see no reason why it can’t continue its fabulous growth for some years yet.
REA Group Limited (ASX: REA), the owner of realestate.com.au, amongst other websites, sports a whopping P/E ratio of over 40! Still, REA has compounded earnings per share growth of 38% over 5 years, and a massive 51% over the past 10 years. The big concern for REA Group is where that high growth will come from next, given its dominant position in Australia. At current prices, REA Group is being priced to continue that growth for many years, which may be difficult.
Carsales.com Limited (ASX: CRZ) appears to be the ‘cheapest’ of the three stocks I’ve mentioned so far, with a forecast P/E ratio of 28.2. Over the past five years, Carsales has grown earnings at 31% each year. However, investing while looking in the rear vision mirror can be hazardous to your wealth, and it’s the future that’s important. And on that note, Carsales is expanding into Asia through its investment in iCar Asia Ltd (ASX: ICQ) as well as investments and joint ventures in other countries. With Asia less ‘developed’, Carsales has the ability to continue to grow earnings at a high rate in future.
ARB Corporation (ASX: ARP), manufacturer of 4WD accessories such as bullbars, has a P/E ratio of over 21. That’s mainly thanks to the company’s ability to generate compound earnings growth of 13% over the past decade. Unfortunately, the future is likely to be very different. What many investors may not know is that ARB is exposed to the slowly deflating resources boom. Investment in the resources sector is expected to drop off dramatically over the next few years, and ARB is fairly and squarely in the firing line. What sort of vehicles do you think mining companies and mining services contractors drive around in? (Hint: they’re not low-slung sports coupes).
My bets are on Seek and Carsales. I suspect REA Group will need to consider more acquisitions to continue to generate high growth which adds a deal of risk, while ARB is supplying products to a declining industry. Unless ARB can find some other levers to pull to generate growth, it’s unlikely to generate growth emulating the last decade, and therefore not entitled to a high P/E ratio.
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Motley Fool writer/analyst Mike King owns shares in Carsales.com and Seek. You can follow Mike on Twitter @TMFKinga