Warning: Don’t Get Burned by Your Hot Stock


Video Transcript:

Hi, I’m Dave Shepherd with Shepherd Wealth and Retirement

Just wanted to go over a real quick concept today that has to deal with price to earnings ratios, and how high P/E ratio companies that really seem to be like the price is gonna go to the moon, why that sometimes comes back and those companies get hurt on their price later. And it has really to do with business cycles. And you may have heard of the S-curve before, but the idea behind the S-curve–a couple things about it– is this is a growing percentage of customers that are using a particular service, and/or new tech, or new product, or whatever. And one of the ideas is that you can cut this into thirds. And the first third of time for a new product or technology is you get to 10% of users. The second third of time you get to 90% of users. And the last third is where you get the last 10% of users, and get to almost full acceptance for whatever product and/or technology. And of course, this is kind of the startup phase and not many people know about it but where companies get their high P/E ratios is when people see customer bases growing like that, just to the moon. And so many times, that is projected onward, that it will go on forever. And right in here is where companies can get those extremely high price to earnings ratios.

And an example today would be Amazon or Netflix. And they are growing their customers and their user bases dramatically. Netflix is actually burning money every month. Amazon’s making it a little bit of profit now. But the idea is they’re on this trajectory that seems like it’s just not gonna stop, and it’s going to go on forever and ever. The same thing happened back in ’99 and 2000, when the tech companies– when we were going through that last push of replacing computers because of Y2K– tech companies looked like they were gonna do the same thing. And, I mean, how many computers can we sell every year? The numbers can’t keep going up. They were projected to go up to, like, four billion computers a year or something if they kept on the same pace. That’s not gonna happen.

So what happened– I’ll give you an example with Cisco.  Cisco at the time went through this kind of a thing. Got up to an extremely high P/E ratio, but the internet, computers, got to a point where this last 10% of customers—now these companies are kind of like utility companies. And they’re just slow growth, mature companies. That’s where you see Apple right now. Apple’s got great earnings, but it’s now here, and it’s not growing as fast as it did in this phase, and its P/E ratio is more normal compared to the market. But what happened with Cisco–Cisco had this, just went sky high, was one of the best stocks in here– and Cisco dropped dramatically and has never gotten back to its high price in 2000. What happened is when Cisco was up at a 60, 70, 80 P/E ratio, it fell back, and now Cisco is right in here with a normalized P/E ratio. They’ve grown their earnings. They’ve grown their profits. But they’re just not growing at this rate anymore.

So what tends to happen– this happened with McDonald’s in the ’70s and the Nifty 50 stocks. Johnson & Johnson and McDonald’s, and some of those companies  that we see as rock solid companies now, in the ’70s were these kind of companies, with 50, 60, 70 P/E ratios. And those prices adjusted and came down, because once all the new technology, all the new thoughts were mainstream, and now we’re getting to 100% of people using the product, it’s now a slower growth blue chip company. So what happened with Cisco–high P/E ratio, got up there, fell in price, never regained its price. Now it’s a very solid company with a more normal, high teens, you know, 16, 17, 18 price to earnings ratio, instead of 60, 70, 80. And the same thing can happen with some of our high-flying stocks today. And it’s just a matter– it’s just inevitable, with the way the business cycle works. So I hope that helps, a little bit more down in the details on P/E ratios there. But it is something that happens over and over and over again, and we always think these stocks are gonna  go to the moon, but as soon as we get to high concentration of customers, that’s when P/E ratios normalize and prices can come way down, unless earnings just go sky high with the stock price.

So hope that helps. Give me a call anytime you have any questions or want to talk about any of this further.
Thank you very much.

About Dave Shepherd, ChFC, CFP®

Dave is the founder of Shepherd Wealth & Retirement in Tucson, Arizona. Dave is a Chartered Financial Consultant (ChFC) and Certified Financial Planner™ practitioner (CFP®). Have a financial question? Click Here to contact Dave Shepherd.

Investment advice offered through Shepherd Wealth Group, a Registered Investment Adviser doing business as Shepherd Wealth & Retirement.

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