When close to half the companies in the United Kingdom have price-to-earnings ratios (or "P/E's") below 16x, you may consider Caledonia Investments Plc (LON:CLDN) as a stock to avoid entirely with its 29.4x 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.
For example, consider that Caledonia Investments' financial performance has been poor lately as its earnings have been in decline. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. If not, then existing shareholders may be quite nervous about the viability of the share price.
View our latest analysis for Caledonia Investments
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 Caledonia Investments' is when the company's growth is on track to outshine the market decidedly.
Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 67%. As a result, earnings from three years ago have also fallen 89% overall. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.
Weighing that medium-term earnings trajectory against the broader market's one-year forecast for expansion of 18% shows it's an unpleasant look.
In light of this, it's alarming that Caledonia Investments' P/E sits above the majority of other companies. 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.
The Key Takeaway
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.
Our examination of Caledonia Investments revealed its shrinking earnings over the medium-term aren't impacting its high P/E anywhere near as much as we would have predicted, given the market is set to grow. 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.
A lot of potential risks can sit within a company's balance sheet. Our free balance sheet analysis for Caledonia Investments 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).
Valuation is complex, but we're here to simplify it.
Discover if Caledonia Investments might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.
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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.