Quora Answer: What are Some Reasons to Invest in a Company with a High Price to Earnings Ratio?

The following is my answer to a Quora question: “What are a few reasons that you would invest in a company with a high price to earnings ratio?”

That really depends.  We cannot look at the P/E by itself.  We need to see it within the context of similar companies in the same industry, or in a benchmark.  This tells us whether the high P/E is due to overvaluation of the stock, or whether there is an expectation of higher earnings growth in the near future.

When it comes to the latter, we have to consider the industry, the economic cycle, economic policy, and the management of the company itself.  There are growth industries and growth regions, and the company should be in the confluence of both.  Economic policy should be favourable to growth in that particular industry the company is in.  And finally, we have to have confidence in the credibility and capability of the management team to take advantage of this.  If the management team is not good enough, all the other favourable factors are wasted.

An example of a stock with a high P/E ratio that was bought is Berkshire Hathaway’s purchase of 6.2% of Coca-Cola in 1987.  Granted, this was after the stock market crash, Black Monday.  But this also demonstrates Warren Edward Buffet’s and Charles Thomas Munger’s acumen in finding a bargain in a bear market, where everybody was liquidating.  Even when the stock recovered, Berkshire Hathaway continued to increase its position, and this was despite the high P/E.

Buffet looked at the balance sheet and saw that Coca-Cola has cash equivalent of almost twice its debt, with a very healthy shareholder equity.  He understood that Coca-Cola was poised for international expansion and acquisition.  Coca-Cola produces thousands of other products besides Coca-Cola.  That means its market share is deceptively small because the average consumer is not aware of how many beverages they buy are actually from Coca-Cola.  This includes juices and bottled water, meaning that the company not only had a healthy share of the market, but was also diversified.  This is the story we look for before investing in a high P/E company.