Some Confidence Is Lacking In The a2 Milk Company Limited (NZSE:ATM) As Shares Slide 26%

The a2 Milk Company Limited (NZSE:ATM) shareholders that were waiting for something to happen have been dealt a blow with a 26% share price drop in the last month. Still, a bad month hasn't completely ruined the past year with the stock gaining 30%, which is great even in a bull market.

Although its price has dipped substantially, a2 Milk's price-to-earnings (or "P/E") ratio of 22.9x might still make it look like a sell right now compared to the market in New Zealand, where around half of the companies have P/E ratios below 19x and even P/E's below 12x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

With its earnings growth in positive territory compared to the declining earnings of most other companies, a2 Milk has been doing quite well of late. The P/E is probably high because investors think the company will continue to navigate the broader market headwinds better than most. If not, then existing shareholders might be a little nervous about the viability of the share price.

Check out our latest analysis for a2 Milk

If you'd like to see what analysts are forecasting going forward, you should check out our free report on a2 Milk.

How Is a2 Milk's Growth Trending?

a2 Milk's P/E ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than the market.

Taking a look back first, we see that the company managed to grow earnings per share by a handy 9.2% last year. This was backed up an excellent period prior to see EPS up by 113% in total over the last three years. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 14% per annum as estimated by the analysts watching the company. With the market predicted to deliver 18% growth per year, the company is positioned for a weaker earnings result.

With this information, we find it concerning that a2 Milk is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

The Key Takeaway

Despite the recent share price weakness, a2 Milk's P/E remains higher than most other companies. 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 a2 Milk's analyst forecasts revealed that its inferior earnings outlook isn't impacting its high P/E anywhere near as much as we would have predicted. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

And what about other risks? Every company has them, and we've spotted 1 warning sign for a2 Milk you should know about.

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).

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.