With a price-to-earnings (or "P/E") ratio of 6.8x Allied Farmers Limited (NZSE:ALF) may be sending very bullish signals at the moment, given that almost half of all companies in New Zealand have P/E ratios greater than 16x and even P/E's higher than 32x are not unusual. However, the P/E might be quite low for a reason and it requires further investigation to determine if it's justified.

Earnings have risen firmly for Allied Farmers recently, which is pleasing to see. It might be that many expect the respectable earnings performance to degrade substantially, which has repressed the P/E. If you like the company, you'd be hoping this isn't the case so that you could potentially pick up some stock while it's out of favour.

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How Is Allied Farmers' Growth Trending?

There's an inherent assumption that a company should far underperform the market for P/E ratios like Allied Farmers' to be considered reasonable.

Retrospectively, the last year delivered an exceptional 16% gain to the company's bottom line. Pleasingly, EPS has also lifted 169% in aggregate from three years ago, thanks to the last 12 months of growth. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Comparing that to the market, which is only predicted to deliver 8.8% growth in the next 12 months, the company's momentum is stronger based on recent medium-term annualised earnings results.

With this information, we find it odd that Allied Farmers is trading at a P/E lower than the market. Apparently some shareholders believe the recent performance has exceeded its limits and have been accepting significantly lower selling prices.

The Bottom Line On Allied Farmers' 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 Allied Farmers currently trades on a much lower than expected P/E since its recent three-year growth is higher than the wider market forecast. When we see strong earnings with faster-than-market growth, we assume potential risks are what might be placing significant pressure on the P/E ratio. At least price risks look to be very low if recent medium-term earnings trends continue, but investors seem to think future earnings could see a lot of volatility.