Investors Still Waiting For A Pull Back In Smith & Nephew plc (LON:SN.)

Smith & Nephew plc's (LON:SN.) price-to-earnings (or "P/E") ratio of 40.7x might make it look like a strong sell right now compared to the market in the United Kingdom, where around half of the companies have P/E ratios below 16x and even P/E's below 9x are quite common. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

Recent times have been advantageous for Smith & Nephew as its earnings have been rising faster than most other companies. 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.

See our latest analysis for Smith & Nephew

If you'd like to see what analysts are forecasting going forward, you should check out our free report on Smith & Nephew.

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

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

Retrospectively, the last year delivered an exceptional 40% gain to the company's bottom line. However, this wasn't enough as the latest three year period has seen a very unpleasant 44% drop in EPS in aggregate. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 46% per year over the next three years. That's shaping up to be materially higher than the 14% per annum growth forecast for the broader market.

In light of this, it's understandable that Smith & Nephew's P/E sits above the majority of other companies. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

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.

As we suspected, our examination of Smith & Nephew's analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. It's hard to see the share price falling strongly in the near future under these circumstances.

There are also other vital risk factors to consider and we've discovered 3 warning signs for Smith & Nephew (1 is a bit unpleasant!) that you should be aware of before investing here.

If you're unsure about the strength of Smith & Nephew's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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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.