Why Most Expensive Stocks Are Rip-Offs

Many investors swear by the “efficient market theory.” All it means is that through the magic of millions of investors buying and selling stock every day, you get what you pay for. If a company is cheap, it’s cheap for a reason. If it’s expensive, it’s expensive for a reason.

I’m a dissenting member of the “efficient market theory” club. First of all, the market runs as much on emotion as it does on logic. And extremes rule. Investors are either too pessimistic or too optimistic.

Instead of the “efficient market theory,” I’d call it the “inefficient market theory.”

The fact is, you hardly ever get what you pay for when you invest. You usually get too little or too much. These days, when it comes to expensive stocks, you get much too little.

There are 153 companies with a price-to-earnings (P/E) ratio of over 100 (according to a search I did on my Yahoo stock screener). If you’re not familiar with P/E ratios, a share price greater than 100 times annual earnings or profits (per share) is very high. To justify such a high price, the company has to grow like the dickens and give every indication of continuing to do so.

I didn’t go through all 153 of those companies. But going through about half of them, I found that just a few earned their high P/E ratios because of strong growth. Usually, it was because their earnings fell faster than their price.

A good example: eBay (EBAY). Its earnings dropped 65 percent over the past 12 months. But its price dropped only 8 percent. At a P/E ratio of 98, its price is now much higher compared to its earnings than it was a year ago. The point is, eBay got more expensive by having a bad year, not a good year.

There are rare exceptions to this pattern, and one comes from overseas. Baidu is China’s Google. Its P/E ratio is 127. But it also grew its earnings over the past year by 95 percent. Phoenix-based First Solar’s (FSLR) P/E ratio is 110. But its earnings grew over 1,000 percent last year.

At one time, you could have argued that Google’s ultra-fast growth in revenue and earnings warranted its high P/E ratio. (It was over 100 for a long time but is now at 40.) But very few of the current crop of super-expensive companies can make such a claim. You should avoid them like the plague… unless you know from looking at past earnings that you have a Baidu or a First Solar on your hands.

[Ed. Note: ETR’s Investment Director, Andrew Gordon, is the editor of INCOME, a monthly financial advisory service that uncovers income-generating stocks that promise safety (first and foremost), along with much-higher-than-average profit potential.]