As we've seen recently, a number of popular but highly-priced businesses like Carsales.Com Ltd (ASX: CAR) and iSentia Group Ltd (ASX: ISD) have been hammered once it became apparent that their prices overestimated the kind of growth they would generate.
They're far from the only companies with big price tags, with Fisher & Paykel Healthcare Corp Ltd (ASX: FPH), Graincorp Ltd (ASX: GNC), SEEK Limited (ASX: SEK), Domino's Pizza Enterprises Ltd. (ASX: DMP) and Treasury Wine Estates Ltd (ASX: TWE) also commanding lofty valuations.
A Nabtrade scan of mid-to-large-cap companies on the ASX also identified Newcrest Mining Limited (ASX: NCM), Oil Search Limited (ASX: OSH), Primary Health Care Limited (ASX: PRY), Sydney Airport Limited (ASX: SYD), Sims Metal Management Ltd (ASX: SGM), and Sirtex Medical Limited (ASX: SRX) as trading on high trailing Price to Earnings (P/E) ratios.
At least some of the above companies have an inflated P/E as a result of one-off charges and the like, while in other cases (Sims Metal) the company has been soaring in the expectation that business will pick up. Others are simply highly priced by a market that expects them to grow at faster-than-average rates.
This is where investors need to be careful, because as we saw with iSentia, paying a high price in anticipation of greater earnings tomorrow can be expensive if those earnings don't eventuate. The father of value investing, Ben Graham even described the process of paying for future earnings – which the company may or may not make – as foolhardy.
A number of the above companies can make a strong case for growth, particularly Treasury Wine and Domino's given their expansions into China and the rest of the world. Yet with the ASX P/E average at around 16 we can clearly see that if growth slows, a re-rating of those stocks to more ordinary levels would absolutely punish share prices. Domino's would be worth about $15 if it had the market average P/E of 16, instead of its current ~75.
This is where investors need to do their research and look closely at the factors influencing a company's earnings before making a decision. The first group of companies I would avoid are miners and oil businesses – they have minimal control over the price they get for their goods. You need a very well-researched opinion in order get away with paying 40 times earnings for a miner (Newcrest) and actually make money.
