The booming share prices of the likes of Fevertree Drinks and ASOS could spark a serious case of ‘fear of missing out’ among some stock market investors, but are these companies simply too expensive to consider buying now?
But their shares have also surged to such a point where they appear eye-wateringly expensive on one popular valuation measure, the price to earnings ratio (P/E ratio).
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The P/E ratio measures the company’s share price against its earnings. The higher the figure the more expensive the stock is generally considered to be.
Fevertree Drinks, the mixer brand which has latched on the public’s booming taste for a gin and tonic, has seen its share price rocket 1,058 per cent in just three years but currently trades at a P/E of more than 100.
ASOS, similarly, has a P/E of 114 and online supermarket Ocado’s P/E ratio stands at a jaw-dropping 256.
To put the figures into context, the historic average P/E ratio for companies on the FTSE 100 is just 15.
Paying over the odds for shares in a company goes against everything a traditional investor hunting for good-value companies believes in.
But the booming value of these firms could very well be justified if earnings continue to rise and performance smashes expectations.
Ian Forrest, investment research analyst at The Share Centre, said: ‘A high P/E ratio generally means the market is expecting the company to grow.
‘To some extent you have to be careful talking about high P/E as it is often that P/E across the sector in general is high. You have to compare the company against others.’
For Fevertree it is clear it is priced above others in the same field. Beverage companies trading on the FTSE 350 are currently priced at 22x earnings on average, while Fevertree is on 101x earnings.
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‘The shares are certainly rated quite highly as a growth stock, despite the £3bn market cap,’ Charles Stanley economist Garry White said.
‘It needs to continue to grow rapidly to justify this market rating.’
It is important to dig a little deeper to make sure the high valuations are justified. If it is trading well above its peers it should ring alarm bells ‘if further analysis doesn’t stand up’, Forrest says.
Using the PEG ratio, a more forward looking valuation of how earnings will move over a number of years, can help work out how risky the company might be. The P/E ratio looks at the value of a company in just one year.
What does a P/E ratio tell you?
- The price to earnings ratio is used to work out how attractive the share price is relative to the earnings of a company
- These figures can be compared to historical and sector averages to gauge value
- A high P/E ratio could suggest the company’s earnings do not justify a high share price
- It is worked out by dividing the latest share price by the company’s earnings per share (EPS)
- The PEG ratio looks at the price, the earnings per share and the company’s expected growth rate
A PEG ratio of more than one would generally mark the company as over-priced, while a score of less than one would be more favourable.
‘It’s quite a good measure because it is looking forward but relating it to the historic performance,’ The Share Centre’s Forrest said.
Unfortunately this all involves diving into company accounts to examine earnings, profits and margins – all easily found and open to the public for listed firms.
Can expectation live up to reality?
James Calder, research director at City Asset Management, believes the companies could easily match future growth expectations – meaning the ratings could well be fair.
‘The rating should reflect the future growth of the company, the ones highlighted here we would consider ‘disruptors’,’ he said, noting how the likes of ASOS and Boohoo have shaken up the traditional high street.
Ocado saw its shares hit four-year highs last week, adding £720m to its value, but they are currently trading at an eye-watering P/E Ratio of 256.
Likewise Ben Hobson, strategies editor at Stockopedia, said the likes of ASOS and Fevertree have a ‘very distinctive profile’ which sets them apart from more traditional companies.
‘They tend to be profitable, fast growing firms but crucially they grow faster than the market expects. What you saw in ASOS and what you see now in Fever Tree is that their figures consistently grow quicker than forecasts.
‘As these kinds of companies grow it naturally gets harder and harder to beat expectations,’ Hobson said.
‘The problem is that the market gets so used to this outperformance that even a modest slowdown in growth could see the share price pull back. There is a huge weight of expectation built into the price, and when growth investors sense a change, many will bail out.’
When dealing with highly-rated companies, and when considering jumping onto the bandwagon to buy shares, it’s important to beware the stage when people’s expectations of how a company will perform outstrip reality.
A well-managed fund or investment trust that pools investors money to invest in a portfolio of these high-growth companies could help spread out the risk.
But importantly, it is perhaps best not to try and wait and see if the valuations fall any time soon, market timing is notoriously difficult to get right.
‘You are getting into market timing then and we have not found anyone that is good at market timing,’ Calder says. ‘If you are waiting for the market to pull back you are waiting for a market correction, then you have to ask what do you miss out on on the way up?’
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