Why the P/E Ratio Might Be Useless.. and What can Replace it?

Countless investors -- individuals and professionals alike -- spend their time seeking out cheap stocks with very low P/E ratios. Sometimes the stocks are cheap are a reason, they are not in favourable industries or have poor fundamentals hidden within. And as a result, the stock prices stay stagnant... sometimes for years! (That is what happened to me once!).

In addition, this creates the notion that stocks with high P/E ratios should be written off as expensive (meaning opportunities often lie hidden in this group).

The problem, though, is that a company with a high P/E ratio may not actually be expensive. A company with a P/E ratio of 50 -- or higher -- may be cheap. Which means...

For some companies, the P/E ratio is meaningless.

It's a bold statement, but stick with me.

You see, the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history -- you're purchasing its future cash flows. What matters is what the company is going to do -- not what it has done.

This is important because there are a slew of companies whose P/E ratio may seem high, but their growth potential is so massive that buying them is still a bargain. And i am talking about High-growth innovative companies that shake up the status quo.

Let's take a look at some examples:

1) Apple (Nasdaq: AAPL ) . Though its P/E ratio is currently just 16, this wasn't always the case.

In fact, during the first quarter of March 2003, Apple's P/E reached as high as 297. Yet had you bought shares of the company then, you'd be up over 7,300% today!

Apple achieved this remarkable success by continuing to innovate, bringing more and more products to market (the iPod, the iPhone, the iPad) that people didn't even realize they needed.

And although it's a $500 billion company today, its stock could still be a smart buy. If Apple continues to innovate and offer enticing products that consumers eagerly snap up, it could easily become a $1 trillion company -- or larger.

2) Intuitive Surgical (Nasdaq: ISRG ) . Its P/E ratio ran as high as 299 during the last quarter of 2004. Yet had you bought shares then, you'd be up more than 1,600% today. A $10,000 investment would be worth over $170,000.

Intuitive Surgical came to market with an innovative medical machine that allowed doctors to perform minimally invasive surgeries on patients. It was a win-win proposition: It allowed more precision for the doctor, meant a quicker recovery time for patients, and less risk for both parties.

Its machines were expensive, but it didn't take long for Intuitive Surgical to convince the medical community of the merits of its device. Now it can continue to find new surgical uses for its machine -- or develop ancillary devices within its niche.

And that's why -- even trading for 42 times earnings today -- Intuitive Surgical could still be a smart investment.

3) Amazon.com (Nasdaq: AMZN ) , the world's largest online retailer, has a P/E ratio of 134. On the face of it, this seems insanely high for a company with a market cap of more than $80 billion. Yet Amazon is furiously building out its empire -- both through acquisitions like Zappos and Diapers.com and through expanding its platform with devices like the Kindle. Not to mention, it also has a growing presence in the cloud computing niche, leasing out server space and offering virtual storage.

So what exactly can replace it?

The previous paragraphs come with a meaning - and that is... do not judge whether a stock is cheap or not using the P/E ratio. Instead You should use a less frequently used indicator known as PEG ratio.

PEG takes into account the growth rate of firms, and just like the examples shown, they become cheap when you value them using PEG.

So.. How does it work?

A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns (the closer to 0 the more undervalued). The PEG Ratio can also be a negative number, for example, when earnings are expected to decline.This may be a bad signal, but not necessarily so. Under many circumstances a company will not grow earnings while its free cash flow improves substantially. 

Here, as in other cases, analyzing the components of PEG becomes paramount to a successful investment strategy. Thus, don't just stop at P/E ratios from now on... move a step in depth to calculate the PEG ratio and you can get all the undervalued stocks and handsome $_$ to come!