Shareholders Should Be Pleased With Smith & Nephew plc's (LON:SN.) Price

When close to half the companies in the United Kingdom have price-to-earnings ratios (or "P/E's") below 14x, you may consider Smith & Nephew plc (LON:SN.) as a stock to avoid entirely with its 30x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

With earnings growth that's superior to most other companies of late, Smith & Nephew has been doing relatively well. The P/E is probably high because investors think this strong earnings performance will continue. If not, then existing shareholders might be a little nervous about the viability of the share price.

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Is There Enough Growth For Smith & Nephew?

In order to justify its P/E ratio, Smith & Nephew would need to produce outstanding growth well in excess of the market.

Taking a look back first, we see that the company grew earnings per share by an impressive 56% last year. Still, incredibly EPS has fallen 21% in total from three years ago, which is quite disappointing. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Turning to the outlook, the next three years should generate growth of 29% each year as estimated by the analysts watching the company. That's shaping up to be materially higher than the 13% 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. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

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 Smith & Nephew maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. Unless these conditions change, they will continue to provide strong support to the share price.

Before you settle on your opinion, we've discovered 2 warning signs for Smith & Nephew that you should be aware of.

Of course, you might also be able to find a better stock than Smith & Nephew. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.