Unpleasant Surprises Could Be In Store For Australian Foundation Investment Company Limited's (ASX:AFI) Shares

When close to half the companies in Australia have price-to-earnings ratios (or "P/E's") below 18x, you may consider Australian Foundation Investment Company Limited (ASX:AFI) as a stock to avoid entirely with its 33.4x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

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For instance, Australian Foundation Investment's receding earnings in recent times would have to be some food for thought. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. If not, then existing shareholders may be quite nervous about the viability of the share price.

See our latest analysis for Australian Foundation Investment

Although there are no analyst estimates available for Australian Foundation Investment, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.

What Are Growth Metrics Telling Us About The High P/E?

The only time you'd be truly comfortable seeing a P/E as steep as Australian Foundation Investment's is when the company's growth is on track to outshine the market decidedly.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 4.4%. The last three years don't look nice either as the company has shrunk EPS by 23% in aggregate. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Weighing that medium-term earnings trajectory against the broader market's one-year forecast for expansion of 21% shows it's an unpleasant look.

With this information, we find it concerning that Australian Foundation Investment is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the recent negative growth rates.

What We Can Learn From Australian Foundation Investment's P/E?

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 Australian Foundation Investment currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. When we see earnings heading backwards and underperforming the market forecasts, we suspect the share price is at risk of declining, sending the high P/E lower. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

You always need to take note of risks, for example - Australian Foundation Investment has 1 warning sign we think you should be aware of.

If P/E ratios interest you, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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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.