For many investors, the price to earnings (P/E) ratio is the Holy Grail and, ultimately, is the deciding factor on whether to buy a slice of a company or not. After all, it is a highly useful ratio and allows fast and easy comparison between companies in different sectors and with differing business models. Furthermore, it is easy to understand and, with time being limited for most Aussie investors due to work and family commitments, it makes sense to use the P/E ratio.
However, just because a company has a higher P/E ratio than the wider index does not necessarily mean that it is not worth buying. In fact, many of the most appealing growth companies on the ASX trade on rich P/E ratios and yet are able to post excellent returns over the medium term.
Take, for example, Newcrest Mining Limited (ASX: NCM). It trades on a P/E ratio of 18.2, which is considerably higher than the ASX's P/E ratio of 16. However, Newcrest seems to be well-worth buying in spite of this, since it is forecast to increase its bottom line at an annualised rate of almost 33% during the next two years. As such, its price to earnings growth (PEG) ratio stands at just 0.56, which indicates that there is considerable upside in Newcrest's share price despite its shares rising by 10% in the last year.
Of course, the outlook for the gold price may be somewhat uncertain. It recently dropped to a five-year low and, with the outlook for the Eurozone being significantly brighter than it was just a few weeks ago, the outlook for gold in terms of it being a safe haven during uncertain periods seems to have been diluted somewhat. Still, with a wide margin of safety, Newcrest has an appealing risk/reward ratio in spite of gold's less appealing outlook.
Meanwhile, packaging company, Amcor Limited (ASX: AMC), also has a high P/E ratio, with its rating standing at 19.8 versus just 11.6 for the wider materials sector (to which Amcor belongs). And, despite its bottom line being forecast to rise by just 2.2% next year, Amcor's longer term future is bright.
For example, it has considerable exposure to non-Australian markets and so is likely to be a major beneficiary of the recent weakening in the Aussie dollar. Furthermore, with a loose monetary policy likely to continue, its bottom line could surpass current guidance – especially since Amcor operates in a number of emerging markets which, over the medium term, are likely to grow at a quicker pace than the domestic market. And, with Amcor having increased its bottom line at an annualised rate of 16.5% during the last five years, the current slow-growth profile seems unlikely to last in 2016 and beyond.
So, while Amcor and Newcrest have relatively high P/E ratios, both stocks appear to justify their rich ratings and seem to be worth buying at the present time.
