When Is A Stock Too Expensive?

Last year, before the stock market sold off, the prevailing thought among many pundits was that stocks were overvalued.

What makes a stock overvalued is very subjective.

Some analysts look at a stock’s price-to-earnings ratio, also known as the PE ratio.  You take the price and divide it by its earnings per share.  So if a company has a PE of 20, that means that it’s trading at 20 times earnings.

You can also look at something called a price/earnings to growth ratio, or PEG ratio.  A PEG ratio of 1 or less indicates that the stock is undervalued.

Now, I personally use neither of these to decide on my stock selections.  My main concern is the size of the company versus the size of the opportunity.

Amazon (NASDAQ: AMZN), for example has always traded at sky-high PE levels.  As a result, many investors passed on it because it was too expensive.

In 2015, Catherine Wood, the founder of ARK Invest, said that Amazon was a trillion-dollar company because the market opportunity was in the multiple trillions.  Amazon had a market value of $200 billion at the time and its PE was over 100 – insanely expensive by traditional metrics.  However, the stock flirted with a market value of a trillion and I’m confident it will get back there.

Great businesses with incredible growth opportunities will always seem expensive, but don’t let that stop you.


