Why P/E Ratios Mislead You on Tech Stocks

When it comes to , price is the variable that can single-handedly veto any deal. You can love a business and admire its management, but if the price isn’t right, you have to walk away. This principle of triangulating between price and value—asking, “What am I getting for what I’m paying?”—is the backbone of any sound investment strategy. At a certain point, even the most incredible business becomes a bad investment if it’s overpriced.

My personal rule is simple: after analyzing a business and its leadership, I look at the price. If I can’t get at least a 5% earnings yield, which translates to paying no more than twenty times its earnings, I won’t buy. In today’s low-interest-rate world, that’s a fair price for a great company. If the market asks for more, I’m content to wait for a better opportunity. For anyone learning , setting a firm price discipline is crucial.

A New Era for Valuing Companies

The approach to has evolved. The old framework, which worked beautifully in the latter half of the 20th century, was built for a stable and relatively static business world. In that environment, using a company's current earnings was a reliable way to figure out what you were getting for your money.

Think of mature giants like Budweiser, Coca-Cola, or Wells Fargo. These companies were already entrenched in their markets. They didn’t need to pour massive sums into building their businesses from the ground up. Their existing profits were a solid proxy for their future profit-generating ability. But the game has changed, especially for digital companies. This shift is fundamental to understanding in the modern economy.

Today’s digital companies operate on a completely different playbook. While a company like Coca-Cola spends less than 30% of its revenue on sales, marketing, and R&D, a software company like Intuit spends around 45%. That 15-point difference is more than the entire net profit margin of an average American business. Campbell’s, the soup maker, dedicates just 12% of its revenue to these areas—about a quarter of what Intuit spends.

This aggressive spending by digital companies distorts their short-term profitability, and serious investors need to understand why.

The Problem with Reported Earnings

At its core, a software business is inherently more profitable than a traditional one. Its raw materials are just zeros and ones. It’s not uncommon to see software companies with 90% gross margins. Mature software giants like Oracle, which don’t reinvest heavily in growth, can hit operating profit margins near 50%. For perspective, Coca-Cola’s margins are about half that.

So why don’t most software companies report these massive profits? Two reasons.

First, accounting rules get in the way. For a digital business, the biggest expenses are R&D and marketing—these are the engines of growth, just like factories were in the Industrial Age. But accounting conventions require companies to expense almost all of these costs immediately. Hard assets like a factory, however, can be depreciated over many years. This rule artificially pushes down the reported earnings of tech companies compared to their old-economy counterparts.

The second, more important point is that it’s simply not in their best interest to maximize current profits. Digital businesses are in growth mode, not harvest mode. They are wisely spending money today to capture enormous future markets. This spending makes the “E” in the P/E ratio look small and the valuation multiple look terrifyingly large. But this is just a misleading snapshot. Comparing Amazon’s current profits to Wells Fargo’s is like comparing an apple orchard in spring to one in the fall. One is just beginning to grow, while the other is ready for harvest. For , this is one of the most important concepts to grasp in .

A Tale of Two Companies: Campbell's vs. Intuit

To make an honest comparison, we have to adjust for this reality. Let's look at Campbell’s and Intuit. In early 2020, Intuit traded at nearly 50 times its reported earnings, while Campbell’s traded for just 20 times. On the surface, Intuit looked far more expensive, offering only a 2% earnings yield compared to Campbell’s 5%.

But was it really? Campbell’s is a classic mature company. Its sales have grown less than 1% annually over the last decade. It faces immense pressure from retailers and its products are seen as off-trend. It makes sense for Campbell’s to spend only 12% of its revenue on R&D and marketing; trying to force growth in mature markets would be a waste of money.

Intuit is in the exact opposite position. Its sales have grown 9% a year, with its key product, QuickBooks Online, growing at over 30% annually. The company estimates it has only captured about 1% of its potential customers. So, of course, it spends heavily—nearly 20% on R&D and 30% on marketing. That’s not an expense; it’s a smart investment. Intuit requires at least a 50% return on its marketing dollars. Any rational person would spend $1 today to make 50 cents in the future, but our financial statements only show the $1 expense. The future profit is invisible. This distinction is key for successful .

Finding a Company's True "Earnings Power"

So, should we penalize Intuit for making smart investments in its future? Or should we adjust its earnings to see what its profitability would look like if it behaved like a mature company? The answer is clearly the latter.

If we mentally put Intuit into "harvest mode" and adjust its spending on R&D and marketing down to Campbell's levels, its earnings explode. Its P/E multiple plummets from over 40 times down to 20 times—the exact same as Campbell’s. Suddenly, the two companies look equally priced. This adjusted figure more accurately reflects what I call "earnings power."

Earnings power isn’t a forecast. It’s a tool that helps quantify a digital company’s underlying ability to generate profit. It allows us to:

1. Put fast-growing tech companies on a comparable footing with mature businesses.
2. Remove accounting distortions that penalize companies for investing in their future.
3. Get a rough but directionally accurate idea of a company's long-term ability to create wealth.

For anyone serious about in today’s market, especially in tech, looking at reported earnings is not enough. The process of successfully in the digital age requires you to look past the surface-level numbers and understand a company’s true earnings power. That is is all about: seeing the reality that the numbers might obscure.