With a price-to-earnings (or "P/E") ratio of 35.6x ARB Corporation Limited (ASX:ARB) may be sending very bearish signals at the moment, given that almost half of all companies in Australia have P/E ratios under 17x and even P/E's lower than 10x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.
ARB has been doing a reasonable job lately as its earnings haven't declined as much as most other companies. The P/E is probably high because investors think this comparatively better earnings performance will continue. While you'd prefer that its earnings trajectory turned around, you'd at least be hoping it remains less negative than other companies, otherwise you're paying a pretty hefty price for no particular reason.
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What Are Growth Metrics Telling Us About The High P/E?
The only time you'd be truly comfortable seeing a P/E as steep as ARB's is when the company's growth is on track to outshine the market decidedly.
Retrospectively, the last year delivered virtually the same number to the company's bottom line as the year before. Fortunately, a few good years before that means that it was still able to grow EPS by 16% in total over the last three years. Therefore, it's fair to say that earnings growth has been inconsistent recently for the company.
Turning to the outlook, the next three years should generate growth of 8.8% per annum as estimated by the six analysts watching the company. With the market predicted to deliver 15% growth per year, the company is positioned for a weaker earnings result.
With this information, we find it concerning that ARB is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.
What We Can Learn From ARB's P/E?
While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.
We've established that ARB currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.
Before you settle on your opinion, we've discovered 1 warning sign for ARB that you should be aware of.
If these risks are making you reconsider your opinion on ARB, explore our interactive list of high quality stocks to get an idea of what else is out there.
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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