LGI Limited's (ASX:LGI) price-to-earnings (or "P/E") ratio of 27.4x might make it look like a strong sell right now compared to the market in Australia, where around half of the companies have P/E ratios below 17x and even P/E's below 9x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.
With earnings growth that's superior to most other companies of late, LGI has been doing relatively well. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. 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?
There's an inherent assumption that a company should far outperform the market for P/E ratios like LGI's to be considered reasonable.
If we review the last year of earnings growth, the company posted a worthy increase of 14%. This was backed up an excellent period prior to see EPS up by 319% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been superb for the company.
Looking ahead now, EPS is anticipated to climb by 17% each year during the coming three years according to the two analysts following the company. Meanwhile, the rest of the market is forecast to expand by 17% per year, which is not materially different.
With this information, we find it interesting that LGI is trading at a high P/E compared to the market. It seems most investors are ignoring the fairly average growth expectations and are willing to pay up for exposure to the stock. Although, additional gains will be difficult to achieve as this level of earnings growth is likely to weigh down the share price eventually.
The Final Word
We'd say 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 LGI currently trades on a higher than expected P/E since its forecast growth is only in line with the wider market. When we see an average earnings outlook with market-like growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.