MY DUMBEST mistake was shorting Amazon.com when its price-to-earnings (P/E) ratio was around 200. No matter what its P/E is, there always seem to be buyers.
- O.W., online
The Fool responds: It's reasonable to steer clear of sky-high P/E ratios, as overvalued companies can be more likely to fall than to keep surging. But there's risk in actually putting money on the expectation that the stock will fall. Remember that a P/E ratio is just that - a simple ratio, dividing a stock's current price by its trailing year of earnings per share (EPS). Amazon's P/E has soared about 3,000 recently, because its EPS fell as it invests heavily in its future. The company's forward P/E, based on expected EPS for next year, is considerably lower, at 98.
Take P/Es into account, but also assess how much you expect a company's value to grow from current levels, factoring in its financial health, competitive strengths and potential. For many years, Amazon has been deemed overvalued, while its stock has kept growing.