National Grid plc's (LON:NG.) Share Price Not Quite Adding Up

With a price-to-earnings (or "P/E") ratio of 18.3x National Grid plc (LON:NG.) may be sending bearish signals at the moment, given that almost half of all companies in the United Kingdom have P/E ratios under 15x and even P/E's lower than 9x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

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With earnings growth that's inferior to most other companies of late, National Grid has been relatively sluggish. One possibility is that the P/E is high because investors think this lacklustre earnings performance will improve markedly. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

See our latest analysis for National Grid

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

Does Growth Match The High P/E?

In order to justify its P/E ratio, National Grid would need to produce impressive growth in excess of the market.

Taking a look back first, we see that there was hardly any earnings per share growth to speak of for the company over the past year. Whilst it's an improvement, it wasn't enough to get the company out of the hole it was in, with earnings down 6.0% overall from three years ago. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 15% each year as estimated by the analysts watching the company. With the market predicted to deliver 15% growth each year, the company is positioned for a comparable earnings result.

In light of this, it's curious that National Grid's P/E sits above the majority of other companies. It seems most investors are ignoring the fairly average growth expectations and are willing to pay up for exposure to the stock. These shareholders may be setting themselves up for disappointment if the P/E falls to levels more in line with the growth outlook.

The Bottom Line On National Grid's P/E

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 National Grid currently trades on a higher than expected P/E since its forecast growth is only in line with the wider market. Right now we are uncomfortable with the relatively high share price as the predicted future earnings aren't likely to support such positive sentiment for long. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 3 warning signs with National Grid (at least 1 which makes us a bit uncomfortable), and understanding them should be part of your investment process.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on a low P/E.

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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.