The a2 Milk Company Limited's (NZSE:ATM) price-to-earnings (or "P/E") ratio of 20.3x might make it look like a sell right now compared to the market in New Zealand, where around half of the companies have P/E ratios below 15x and even P/E's below 10x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

With its earnings growth in positive territory compared to the declining earnings of most other companies, a2 Milk has been doing quite well of late. 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.

See our latest analysis for a2 Milk

If you'd like to see what analysts are forecasting going forward, you should check out our free report on a2 Milk.

How Is a2 Milk's Growth Trending?

a2 Milk's P/E ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than the market.

Taking a look back first, we see that the company grew earnings per share by an impressive 29% last year. Despite this strong recent growth, it's still struggling to catch up as its three-year EPS frustratingly shrank by 59% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 16% per year over the next three years. That's shaping up to be materially lower than the 21% per annum growth forecast for the broader market.

With this information, we find it concerning that a2 Milk is trading at a P/E higher than the market. 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. Only the boldest would assume these prices are sustainable as this level of earnings growth is likely to weigh heavily on the share price eventually.

The Final Word

Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that a2 Milk 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.