Although mathematically simple, taking a company’s price and dividing it by its earnings can tell an investor a great deal. The P/E ratio, as it is called, shows how much investors are willing to pay for a dollar of earnings. So, if a company has a stock price of $20 and earnings of $1.00, its P/E would be 20. Each dollar of earnings is worth $1 to the market. If that same company, trading at $20 per share, earned $0.50, however, the P/E would be 40—investors would be paying $2.00 for each dollar of earnings.
The price to earnings ratio is a valuation metric, helping to decipher if a stock is expensive or cheap. Although some use absolute metrics (a P/E over 20 is expensive, for example), P/E is most useful on a relative basis, comparing one company to its historical trends, to another company, or to an industry or market average. It is a way to measure that voting machine mentality of Wall Street about which Benjamin Graham wrote. The thought is that growth and momentum investors are willing to pay more for a dollar of today’s earnings to invest in a quickly growing company. A value investor, meanwhile, would prefer to wait until a company is “on sale” and trading at a low P/E multiple.
Every week Value Line publishes screens of the highest and lowest P/E ratios in the Index section of The Value Line Investment Survey. Although the common refrain is that value seekers should focus on the lowest P/E screen and growth and momentum investors should focus on companies with higher P/Es, this isn’t always true. The high P/E screen often turns up companies in the midst of a turnaround. So, while growth and momentum investors may find quickly growing companies on the high P/E list, value investors willing to sort through the 100 names that make the high P/E screen can also find some hidden gems.
A recent screen turned up rapidly growing companies like Chipotle Mexican Grill (CMG), Ceva Inc. (CEVA), and Informatica Corp. (INFA).
Chipotle Mexican Grill
The company currently operates 1,128 restaurants throughout the United States, 4% more than it did at the end of 2010. It uses fresh ingredients to prepare tacos, burritos, salads, and burrito bowls (a burrito without the tortilla) from scratch. Customers speak directly to the employees that prepare their food and each order can be ready in less than a minute. The majority of meat bought by the company is naturally raised, meaning the animals are fed a pure vegetarian diet, never given antibiotics or hormones, and raised humanely. Due to these stringent food quality requirements, Chipotle may fail to secure top-quality ingredients at reasonable prices. This is a risk management is willing to take since it believes consumers’ increasing concern about where and how food is raised will drive demand over the long term.
The company delivered impressive growth in the second quarter, with same-store sales climbing 10%, the fourth consecutive quarter of double-digit gains. However, earnings per share came in less than expected owing to inflated food costs, which offset labor and operating cost leverage. In response, the company has decided to raise prices, which may well benefit margins and revenues in the coming quarters.
Indeed, management raised its estimate for same-store sales by a substantial degree, reinforcing the justification for CMG’s lofty P/E ratio. Looking long-term, the company’s aggressive growth strategy and strong customer loyalty ought to ensure revenue growth remains impressive.
Informatica is a leading provider of enterprise data integration and data quality software and services that reduce data fragmentation and complexity, helping companies grapple with multiple data silos, formats, and varied data quality. Its technology allows customers to access, discover, cleanse, integrate, and deliver data, while improving its quality. This provides clients with increased operational efficiency, reduced costs, a comprehensive view of customers, and more useful business information.
Strong demand for the company’s products drove revenues up 23% year over year in the June interim. A standout was the application information lifecycle management product which is designed to help IT organizations conduct the development, testing, archiving, and retirement of data more efficiently, thus reducing costs. Further, the Informatica Cloud platform is growing at a healthy pace, as those applications allow business users to integrate data across cloud-based applications and on-premise systems and databases. Revenues originating from clients in the financial services, technology and communications sectors have been particularly strong of late.
Informatica’s leading market share in an underrepresented field make it well positioned to continue benefiting from “big data” or datasets that grow so large that they become difficult to work with and extract relevant information from. Although the company is not immune to economic downturns, it is somewhat insulated due to the growing necessity of its products. Also, the recent depreciation of its stock price has reduced the P/E ratio by approximately 25%.
Ceva is the world’s leading licensor of silicon intellectual property. Its technology is licensed to leading semiconductor and OEM companies throughout the world. These clients incorporate Ceva’s intellectual property into integrated circuits that are customized for a particular use. The company’s share of the licensable Digital Signal Processor (DSP) market is 78%. A DSP converts an analog signal (i.e. a human voice or music) into digital form for devices such as mobile phones and tablets. In 2010, CEVA’s licensees shipped 613 million chipsets, an increase of 83% over 2009.
The company appears well positioned to benefit from the transition to 3G and Long Term Evolution (LTE) data plans considering its makes significantly more licensing fees for mobile devices that incorporate these standards. This should permit increased average selling prices in the months ahead, and in turn boost the bottom line. The company also stands to benefit from the rising number of features found in smartphones sold in China and India, making it less susceptible to potentially weaker smartphone demand in developed nations than other companies in the cellphone space. Too, although the P/E remains high on an absolute basis, recent market weakness has made this metric more reasonable compared to industry peers, limiting downside risk to a degree.
At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.