ASX shares trade on a wide range of valuations. We can still make really good returns on ones with high price/earnings (P/E) ratios if they deliver strong profit growth.
It might be easy to say that a business with a high p/e ratio seems expensive and that a low one is cheap. But it's not that easy.
A P/E ratio is just a snapshot of what multiple of earnings the company is trading at compared to its share price.
The current P/E ratio might be useful to judge a business that doesn't see that much profit growth in each result, such as ANZ Group Holdings Ltd (ASX: ANZ). But a high P/E ratio may simply be reflecting the potential of future growth. The profit they make in FY25 could justify today's P/E ratio.
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Why a high P/E ratio can work out
When we think about ASX shares with high P/E ratios, names like Pro Medicus Ltd (ASX: PME), Altium Limited (ASX: ALU) and TechnologyOne Ltd (ASX: TNE) may come to mind.
Look at the last five years of capital growth of these companies.
The Pro Medicus share price has risen by 710%.
The Altium share price has gone up 85%.
The TechnologyOne share price has climbed 215%.
But if we look back five years, the P/E ratios of these businesses weren't exactly low.
The Pro Medicus share price was valued at 68 times FY18's earnings.
The Altium share price was valued at 52 times FY18's earnings.
The TechnologyOne share price was priced at 31 times FY18's earnings.
How have these companies managed to deliver such strong returns?
I'd suggest it's down to the fact that each of these businesses has delivered great profit growth which has justified the valuation.
If profit is growing really quickly, it can more than makeup for a reduction of the P/E ratio. For example, if profit grows by 20% in one year, but the P/E ratio only falls by 10%, then investors can get a pleasing double-digit share price return.
With the great ASX shares I've mentioned, the P/E ratio hasn't really deteriorated at all and their profit growth outlook is still very promising.
Winners keep on winning
I think one of the most important things to remember in investing is that great businesses usually don't just fall over suddenly. If they keep investing in their products and services and remain focused, they can keep winning year after year.
Just think about Microsoft, it's almost 50 years old and continues to have a very promising growth outlook.
Apple is well over 40 years old but keeps winning and innovating.
On the ASX, I think it's highly likely that many of the ASX shares that have done well are going to be able to keep growing profits. Though I'm not necessarily suggesting that today is the best day to buy into Pro Medicus shares.
