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There is a strange ritual that happens every earnings season. A young technology company reports its numbers, and somewhere on financial television, a serious looking analyst frowns at the screen and says the dreaded words. The stock is trading at a price to earnings ratio of 180. Or 400. Or, in some particularly amusing cases, the ratio simply does not exist because there are no earnings to divide by. The analyst will then declare the stock dangerously overvalued, perhaps even a bubble, and recommend that sensible investors stay away.
A few years later, that same stock has tripled, and the analyst is on a different network explaining why they always believed in it.
This is not a story about bad analysts. It is a story about a bad tool being used for the wrong job. The price to earnings ratio is one of the oldest measures in finance, and for many businesses it works beautifully. But when you apply it to a high-growth technology company, you are essentially using a wooden ruler to measure the temperature of soup. The instrument is fine. The application is absurd.
The Tool Was Built for a Different World
To understand why the P/E ratio struggles with modern technology, you have to understand what it was designed to measure in the first place. Benjamin Graham and the founding fathers of value investing lived in a world dominated by industrial firms. Steel mills. Railroads. Manufacturers of soap and tractors. These businesses had a beautiful predictability to them. You knew roughly how much it cost to build a factory, how much that factory could produce, and how much profit each unit would generate. Earnings were not just a number. They were a faithful reflection of the underlying business.
In that world, comparing the price of a stock to its earnings made enormous sense. If you paid fifteen times earnings for a company, you were essentially buying a fifteen year payback period on a relatively stable cash machine. The future looked a lot like the present, which looked a lot like the past.
Now consider a software company in its early years. It is building something that did not exist before. Its costs are front loaded, meaning it spends enormous amounts of money today on engineers, data centers, and marketing to acquire customers who will, hopefully, stay for a decade or more. Its earnings, if any, are deliberately suppressed because every spare dollar gets reinvested into growth. The faster it grows, the worse its current earnings look. The ratio is not measuring what you think it is measuring.
It is a bit like judging a marathon runner by how tired they look at mile three. The exhaustion is not a sign of weakness. It is a sign of effort that will pay off later, when the slower runners have already given up.
Earnings Are an Accounting Story, Not a Truth
Here is something they do not emphasize enough in introductory finance classes. Earnings are not a fact. They are a narrative chosen from a menu of acceptable narratives. Accountants make decisions every quarter about how to categorize spending, how to depreciate assets, how to recognize revenue. These decisions are guided by rules, but the rules leave plenty of room for storytelling.
For a railroad, the storytelling is fairly mild. A locomotive is a locomotive. It costs a certain amount and lasts a certain number of years. The math is boring and reliable.
For a software company, the storytelling becomes wild. When a company spends hundred million dollars on engineers to build a product that will generate revenue for the next twenty years, accounting rules generally force them to expense that cost immediately. It hits the income statement like a wrecking ball. But economically, that money is not gone. It is sitting inside the company in the form of code, intellectual property, customer relationships, and brand recognition. None of it shows up properly in earnings.
Compare this to a factory that costs a hundred million dollars. The accounting world treats the factory as an asset. It gets depreciated slowly over decades. Earnings barely flinch. The same economic reality, two completely different reported outcomes.
So when you look at the P in P/E, you are looking at a real number. The market has set a price. When you look at the E, you are looking at a story that someone wrote according to certain conventions. Dividing one by the other gives you a ratio. Whether it tells you anything meaningful depends entirely on whether the story is a good description of reality. For high growth tech, it usually is not.
The Compounding Problem That Breaks the Math
A company growing earnings at five percent a year and a company growing earnings at fifty percent a year are not on the same scale. They are not even in the same conversation. After ten years, the slow grower has roughly doubled its earnings. The fast grower has multiplied them by nearly sixty. After fifteen years, the gap becomes almost cartoonish.
Now think about what a P/E ratio is really asking. It is asking how many years of current earnings you are paying for the stock. If a company trades at twenty times earnings and grows slowly, that ratio is meaningful. You are paying twenty years of something close to today’s profits. If a company trades at two hundred times earnings but its earnings will be one hundred times larger in ten years, you are actually paying two years of future earnings, not two hundred.
The ratio is not lying. It is just answering a question nobody should be asking. The question is not what you are paying relative to what the company earns today. The question is what you are paying relative to what the company will earn when it matures. And no one can compress that into a single ratio that fits in a stock screener.
This is the part that drives serious investors slightly mad. The market is not stupid when it puts huge multiples on growing companies. It is simply doing the math that the P/E ratio refuses to do.
The Twist About Profitable Companies
Here is something that sounds wrong until you sit with it for a moment. A high-growth technology company that becomes very profitable very quickly might actually be a worse business than one that stays unprofitable for years.
I will say that again because it sounds insane. Early profitability can be a warning sign, not a virtue.
The reason is straightforward. If a company has a massive opportunity in front of it, the rational thing to do is to grab as much of it as possible before competitors arrive. That means spending aggressively on growth, even at the cost of looking unprofitable on paper. A company that reports nice clean profits early on is often a company that has decided its opportunity is small, or one that has run out of good ways to invest in itself.
Amazon spent roughly two decades being mocked for its lack of profits. Every year, financial commentators wrote articles asking when the company would finally make real money. Every year, Jeff Bezos shrugged and reinvested everything into building warehouses, cloud infrastructure, and logistics networks. The P/E ratio during those years was either absurdly high or undefined. By the conventional measure, Amazon was always overvalued. By the actual measure of business value created, it was one of the great bargains in market history.
Meanwhile, plenty of mature companies with reasonable P/E ratios slowly faded into irrelevance, paying their dividends and shrinking their market share. They looked cheap. They were cheap for a reason.
This is the paradox the P/E ratio cannot handle. Sometimes the most expensive looking stock is the cheapest one, and the cheapest looking stock is the most expensive.
The ratio measures the past. The value lives in the future.
What People Actually Mean When They Cite High Multiples
When someone points to a sky high P/E and gasps, they are usually expressing one of two real concerns, and it would be more useful if they just said the concerns directly.
The first concern is that the growth might not actually happen. A company priced for spectacular future earnings is a company that will be punished if those earnings disappoint. This is a real risk, but it has nothing to do with the current P/E ratio. It has to do with the believability of the growth story. The ratio is just the symptom of the market’s belief in that story.
The second concern is that even if the growth happens, the price already reflects it. In other words, you might be right about the company and still lose money because everyone else was also right and got there first. This is also a real concern, but again it is a question about the future, not about a ratio computed from last year’s accounting numbers.
If you find yourself dismissing a technology company because its P/E is high, take a moment to ask what you actually mean. Do you think the growth will fail? Then say that, and explain why. Do you think the price has run ahead of even the optimistic case? Then say that, and explain why. The ratio is a placeholder for an opinion you have not bothered to articulate.
A Better Lens
None of this means valuation does not matter. Of course it matters. Price is what you pay and value is what you get, as one famous investor liked to repeat. The point is simply that for high-growth technology companies, the path to figuring out value runs through different territory than the P/E ratio suggests.
You want to think about the size of the opportunity the company is chasing. You want to think about whether the business gets stronger or weaker as it gets bigger. You want to think about how durable its advantages are, how long the growth can continue, how much cash the business will eventually throw off when it stops reinvesting every dollar into expansion. These are messy questions that do not collapse into a single number, which is precisely why people avoid them. It is easier to look at a P/E ratio and feel like you have done analysis.
But easy analysis on the wrong question is not analysis. It is theater. And the audience for that theater is usually the analyst themselves, performing rigor for an imaginary observer.
The P/E ratio is still useful. Use it on a utility company. Use it on a regional bank. Use it on a soda manufacturer. Just stop pretending it has anything intelligent to say about a business that is busy reshaping the future.
You might as well ask a thermometer to weigh your luggage.
