This article was originally published in our weekly newsletter.

The price-to-earnings ratio (P/E) is a measurement used to evaluate a stock's value.

Essentially, it compares the current price of a stock (what the market decides) to its business earnings (the net income or profit of the business).

If a company has a high P/E ratio, it means investors are paying a high price for something that may not have as much current value based on its current business performance.

Generally speaking, when the P/E ratio goes above 30x, it may be considered expensive or overvalued.

The S&P 500 typically averages a P/E Ratio of around 15x to 22x.

Today, it’s around 28x.

That means the market may be overpriced.

I’m not too concerned about the market and its P/E ratio because it can be a lagging indicator, meaning stocks may be increasing at the same time that companies are experiencing significant growth.

Sometimes, it takes a few months for the P/E ratio to catch up and meet market expectations.

However, there are a few stocks out there that have what I would consider high P/E Ratios.

These stocks also have significant momentum behind them, meaning many people continue to buy them, which drives up the price.

That could be contributing to a potential future bubble.

For example, Palantir Technologies, a popular growth stock, has a P/E ratio of around 550x.

Tesla has a P/E ratio of around 132x.

Monday has a P/E Ratio of around 300x.

These current P/E ratios only make sense if the company experiences significant growth and increased profits or earnings per share.

For example, let’s say the stock is priced at $100 per share and has a P/E ratio of 200x.

That stock would need to increase its earnings per share (EPS) by 10x in order to have a P/E ratio of around 20x (a normal P/E ratio), assuming the share price remains the same.

That’s a 900% increase in earnings.

If the stock price continues to rise faster than the company’s earnings, the P/E ratio would remain elevated, making the stock appear overvalued.

This adds risk for investors, since any slowdown in growth or earnings could lead to a sharp correction.

If you look back at the late 90s, you’ll find similar situations.

Before the 2000 dot-com crash…

Cisco had a P/E ratio of 148x to 222x.

Oracle had a P/E ratio of around 153x.

Qualcomm had a P/E ratio of around 167x.

Microsoft had a P/E ratio of 61x to 70x.

Intel had a P/E ratio of around 74x.

The NASDAQ, which is heavily weighted in tech, had a P/E ratio of around 200x.

Here’s what happened to all of these stocks (and the NASDAQ) in 2000, 2001, and 2002.

Know the risk you are taking.

Yes, it may have been profitable for the past couple of years.

That doesn’t mean it will remain profitable for many years to come.

The Takeaway

Be cautious of any stock or index that has a higher P/E ratio.

The higher the ratio, the greater the risk you may be taking.

When people say “the market is overbought” or “the market is overvalued,” they often point to the high P/E ratio.

Robert Shiller and John Campbell’s research introduced the Cyclically Adjusted P/E (CAPE), a 10-year average inflation-adjusted P/E calculation, which found that poor long-term returns or market declines often followed high CAPE.

Many market observers, such as Pimco, note that when markets reach levels around a 37x P/E ratio, it can lead to sharp market corrections.

LPL Research found that high P/E ratios often predict lower future returns.

Numerous other studies have been conducted to yield similar results.

When the P/E ratio is high, crashes, flat market cycles, and similar events are more likely to occur.

Are you going to lock in some of your returns and adopt a more conservative approach that can help you preserve your money?

Or are you willing to accept the risk you are taking, acknowledging that these positions may decline quickly, and see what happens?

The choice is yours to make.