Why investors shouldn't rule out buying high p/e ASX shares

Big earnings multiple stocks can still make big returns.

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Key points

  • An easy way to judge a business is to compare what multiple of earnings it’s valued at – the price/earnings (p/e) ratio
  • A higher pe/e ratio business can have more quality or defensive earnings
  • Businesses that are growing earnings at a faster rate can justify a higher p/e ratio

ASX shares can make good returns for investors, whether they have a high price/earnings (p/e) ratio or a low one.

We can easily compare different profit-making businesses by looking at the multiple of earnings that they're trading at.

It might be simple enough to think that a business with a low p/e is better value than a higher p/e business. That might be true, but it could be looking at the wrong statistic. A p/e ratio is just a snapshot of that one business compared to its earnings for that year.

I'm going to run through two of the main reasons why a higher p/e ratio doesn't necessarily have to be a turn-off.

High-quality earnings

A business with strong earnings may be more reliable than a business with volatile or challenged earnings.

For example, a business with mostly-subscription based revenue (and profit) has high visibility of its earnings because much of its revenue is locked in for the next year and beyond. Businesses like Altium Limited (ASX: ALU) and Pro Medicus Ltd (ASX: PME) have a high proportion of revenue that is recurring.

We can also say that some earnings are from businesses in defensive sectors, such as supermarket retailers like Coles Group Ltd (ASX: COL) or funeral operators such as Propel Funeral Partners Ltd (ASX: PFP).  

Certainly, a business in the mining sector or discretionary retailing sector may have a good year, but the profit could halve in the following year. So, the p/e ratio is usually lower for those ASX shares in recognition of that unpredictability.

Stronger growth

A business may also have a higher p/e ratio because it's reflecting the profit growth that it may achieve in future years.

An ASX share could trade at 10x this year's earnings. If the profit doesn't grow, and the share price doesn't change, then it would still be at 10x earnings and may still appear cheap.

Alternatively, there could be a business that trades at 25x this year's earnings, but if its profit rises by an average of 20% per year for the next few years, then the p/e ratio could steadily fall (and seem more attractive), or the share price could grow at a relatively fast pace.

Businesses like Microsoft and Alphabet have typically traded on a higher p/e ratio than the US share market, but they have performed excellently over the past decade because of the earnings growth that they have generated.

Foolish takeaway

Of course, it can make sense to consider a business when it's trading at a lower price, which comes with a lower p/e ratio.

We can also use the p/e ratio to compare different businesses to decide if one is better value than another, such as comparing Coles and Woolworths Group Ltd (ASX: WOW).

O course, businesses can become overvalued and we shouldn't pay crazy prices if it doesn't make sense for the future. However, with some businesses, it can be worthwhile paying a little more because they can deliver more.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Motley Fool contributor Tristan Harrison has positions in Altium. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Alphabet, Altium, and Pro Medicus. The Motley Fool Australia has positions in and has recommended Coles Group. The Motley Fool Australia has recommended Alphabet, Pro Medicus, and Propel Funeral Partners. 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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