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Electrocomponents plc's (LON:ECM) price-to-earnings (or "P/E") ratio of 19.5x might make it look like a sell right now compared to the market in the United Kingdom, where around half of the companies have P/E ratios below 17x and even P/E's below 9x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.
Electrocomponents certainly has been doing a good job lately as its earnings growth has been positive while most other companies have been seeing their earnings go backwards. It seems that many are expecting the company to continue defying the broader market adversity, which has increased investors’ willingness to pay up for the stock. You'd really hope so, 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?
In order to justify its P/E ratio, Electrocomponents would need to produce impressive growth in excess of the market.
Taking a look back first, we see that the company managed to grow earnings per share by a handy 3.9% last year. Pleasingly, EPS has also lifted 66% in aggregate from three years ago, partly thanks to the last 12 months of growth. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.
Turning to the outlook, the next three years should generate growth of 4.7% each year as estimated by the eleven analysts watching the company. With the market predicted to deliver 13% growth each year, the company is positioned for a weaker earnings result.
In light of this, it's alarming that Electrocomponents' P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. 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.
The Bottom Line On Electrocomponents' P/E
The price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.
We've established that Electrocomponents currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.