There's Reason For Concern Over ARB Corporation Limited's (ASX:ARB) Price

With a price-to-earnings (or "P/E") ratio of 36.9x ARB Corporation Limited (ASX:ARB) may be sending very bearish signals at the moment, given that almost half of all companies in Australia have P/E ratios under 19x and even P/E's lower than 10x are not unusual. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

ARB certainly has been doing a good job lately as it's been growing earnings more than most other companies. 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.

Check out our latest analysis for ARB

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

Is There Enough Growth For ARB?

ARB's P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.

Taking a look back first, we see that the company grew earnings per share by an impressive 16% last year. Despite this strong recent growth, it's still struggling to catch up as its three-year EPS frustratingly shrank by 11% overall. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 9.0% per annum over the next three years. With the market predicted to deliver 18% growth each year, the company is positioned for a weaker earnings result.

In light of this, it's alarming that ARB's P/E sits above the majority of other companies. 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. 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 Key Takeaway

While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

We've established that ARB 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. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

A lot of potential risks can sit within a company's balance sheet. Take a look at our free balance sheet analysis for ARB with six simple checks on some of these key factors.

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).

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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.