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Should the Xero share price have a P/E ratio of 4,000?

The Xero Limited (ASX: XRO) share price has been a top ASX tech performer for quite some time. Shares in the Aussie software provider are up 11.66% this year while the S&P/ASX 200 Index (ASX: XJO) has slumped 11.11% lower.

But there’s one that thing that really stands out about Xero right now. The Aussie tech group’s shares trade at a price to earnings (P/E) ratio of 4,122.29. That’s a pretty astonishing number, but does it mean Xero is overvalued today?

Is the Xero share price overvalued?

Xero is currently trading at $89.33 per share. A P/E ratio of 4,122 means that for every $4,122 you pay for the share, you can expect the company to generate $1 worth of earnings.

That’s an incredibly high number. Let’s compare that figure that to a strong dividend share like Fortescue Metals Group Limited (ASX: FMG). Fortescue shares are currently valued at $14.66 with a P/E ratio of 6.04.

Of course, we have to compare apples with apples. This means it might be more appropriate to evaluate the Xero share price against that of its WAAAX peers. The Altium Limited (ASX: ALU) share price, for example, currently trades at a P/E ratio of 62.16. Therefore, on the surface it might appear that Xero shares are grossly overvalued.

However, I don’t think it’s that simple. The Xero share price has consistently climbed over the years and investors continue to buy into the company. The group continues to sign big clients and I think small and medium business clients will rely on Xero software throughout the COVID-19 crisis. 

Furthermore, many ASX tech shares don’t actually post positive earnings or ‘profit’. That means the earnings component of the P/E ratio is useless and won’t provide any decisive value. However, if a company posts a 1 cent per share profit, all of a sudden their P/E ratio will be enormous.

Foolish takeaway

I don’t think it’s wise to just use P/E ratios to value the Xero share price, particularly in the current climate. If Xero retains key customers and manages to reduce churn, the ASX tech share could still be a good buy in 2020 and beyond.

Where to invest $1,000 right now

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Scott just revealed what he believes are the five best ASX stocks for investors to buy right now. These stocks are trading at dirt-cheap prices and Scott thinks they are great buys right now.

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Motley Fool contributor Ken Hall has no position in any of the stocks mentioned. 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.

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