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3 reasons why you shouldn’t worry about the high p/e of a share

There are some investment lessons and strategies that are many decades old and can rightly be used to evaluate ‘value’ shares. Those businesses that operate in old school industries that have been around for decades have many comparables.

However, increasingly these days several businesses are trading on price/earnings ratios that are far in excess of the market’s average. How can you justify investing in something that is trading at least twice as expensively as the market?

Well, I think there a few reasons why you can justify it:

Australia’s large businesses offer little growth

Initially, I was going to write that the large blue chips offer no growth, but that’s probably not true. A key reason why the share market is so much better than cash, even with mediocre businesses, is that inflation plus population growth alone adds a decent amount of money into the economy each year. Those big businesses just need to maintain market share to grow profit by a few percent and payout a decent fully franked dividend. This return will handily beat cash and provide solid income from Australia’s blue chips.

But, I’m looking for long-term growth far better than a couple of percent from inflation plus a couple of percent from population growth. Australia’s market average is mostly linked to the slow-growth companies like Commonwealth Bank of Australia (ASX: CBA), Telstra Corporation Ltd (ASX: TLS) and Woolworths Group Ltd (ASX: WOW).

Compounding works with profits too

When I think of compound interest, I mostly relate to how cash in my bank or how dividends re-invests to create more wealth.

The strongest compounder of money is probably a business’ profit. Business that earn high rates of return on money invested in the company are money making machines. If that business is earning 30% or more on each dollar invested in the business, and can do so with additional money re-invested back into the company, then it can compound its profits very attractively.

Over time these growth machines easily grow into their once-large valuations. Assuming that company hasn’t hit its growth ceiling after a few years, it will likely keep growing for years to come and therefore still command a high p/e ratio. Think how much CSL Limited (ASX: CSL) has grown in recent years, yet it’s still investing heavily in R&D now for future growth.

Technology companies

The technology industry wasn’t really a ‘thing’ until the last two or three decades. The dot com boom and bust was clearly a disaster waiting to happen – companies weren’t even generating revenue and being assigned large valuations.

However, these days there are many, many technology businesses that are generating real revenue and real profit. Most of them have truly global addressable markets, which means that they have long-term growth runways. Most of them are investing back into the business at high rates of returns.

Most of them have very high gross margins. The great thing about software is that once it’s developed it can be rolled out to each new customer for extremely little cost. This turns most of the revenue growth into profit growth. For this reason, I think a lot of tech companies are worthy of the higher valuations, particularly when they have defensive earnings profiles.

Despite the high current valuations applied to Altium Limited (ASX: ALU) and Xero Limited (ASX: XRO), for example, if you think where they will be in five or ten years’ time and today’s price could be cheap! Think of Facebook when it listed – it was considered expensive, yet multitudes of the price later it is now deemed cheap and still growing fast.

Whilst debt, management teams and other factors should still be strongly considered, valuation is one thing that may not be as important in the short-term these days if that business has heaps of growth left in store.

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Motley Fool contributor Tristan Harrison owns shares of Altium. The Motley Fool Australia owns shares of and has recommended Telstra Limited. The Motley Fool Australia owns shares of Altium and Xero. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.