When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 18x, you may consider A. O. Smith Corporation (NYSE:AOS) as a stock to potentially avoid with its 21.2x P/E ratio. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.
Recent times have been pleasing for A. O. Smith as its earnings have risen in spite of the market's earnings going into reverse. The P/E is probably high because investors think the company will continue to navigate the broader market headwinds better than most. If not, then existing shareholders might be a little nervous about the viability of the share price.
What Are Growth Metrics Telling Us About The High P/E?
The only time you'd be truly comfortable seeing a P/E as high as A. O. Smith's is when the company's growth is on track to outshine the market.
If we review the last year of earnings growth, the company posted a terrific increase of 116%. The latest three year period has also seen an excellent 44% overall rise in EPS, aided by its short-term performance. 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 7.8% each year during the coming three years according to the analysts following the company. That's shaping up to be materially lower than the 10% per annum growth forecast for the broader market.
With this information, we find it concerning that A. O. Smith 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. 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
Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.
We've established that A. O. Smith 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.
Many other vital risk factors can be found on the company's balance sheet. Our free balance sheet analysis for A. O. Smith with six simple checks will allow you to discover any risks that could be an issue.
It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
