Allegro MicroSystems, Inc.'s (NASDAQ:ALGM) price-to-earnings (or "P/E") ratio of 26.3x might make it look like a strong sell right now compared to the market in the United States, where around half of the companies have P/E ratios below 16x 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.

Allegro MicroSystems 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. If not, then existing shareholders might be a little nervous about the viability of the share price.

Want the full picture on analyst estimates for the company? Then our free report on Allegro MicroSystems will help you uncover what's on the horizon.

How Is Allegro MicroSystems' Growth Trending?

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

If we review the last year of earnings growth, the company posted a terrific increase of 44%. Pleasingly, EPS has also lifted 96% in aggregate from three years ago, thanks to the last 12 months of growth. So we can start by confirming that the company has done a great job of growing earnings over that time.

Turning to the outlook, the next three years should bring diminished returns, with earnings decreasing 4.3% per annum as estimated by the seven analysts watching the company. That's not great when the rest of the market is expected to grow by 11% per year.

With this information, we find it concerning that Allegro MicroSystems 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. There's a very good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the negative growth outlook.

The Key Takeaway

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

We've established that Allegro MicroSystems currently trades on a much higher than expected P/E for a company whose earnings are forecast to decline. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings are highly unlikely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

The company's balance sheet is another key area for risk analysis. Take a look at our free balance sheet analysis for Allegro MicroSystems with six simple checks on some of these key factors.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on a low P/E.

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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.