Risks To Shareholder Returns Are Elevated At These Prices For Pearson plc (LON:PSON)

When close to half the companies in the United Kingdom have price-to-earnings ratios (or "P/E's") below 16x, you may consider Pearson plc (LON:PSON) as a stock to potentially avoid with its 19.8x P/E ratio. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

With earnings growth that's superior to most other companies of late, Pearson has been doing relatively well. The P/E is probably high because investors think this strong earnings performance will continue. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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Does Growth Match The High P/E?

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

Retrospectively, the last year delivered an exceptional 24% gain to the company's bottom line. The latest three year period has also seen an excellent 42% 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 10% per year during the coming three years according to the nine analysts following the company. Meanwhile, the rest of the market is forecast to expand by 14% per year, which is noticeably more attractive.

With this information, we find it concerning that Pearson 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. 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

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 Pearson currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

Don't forget that there may be other risks. For instance, we've identified 1 warning sign for Pearson that you should be aware of.

If these risks are making you reconsider your opinion on Pearson, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.