The a2 Milk Company Limited's (NZSE:ATM) Share Price Not Quite Adding Up

The a2 Milk Company Limited's (NZSE:ATM) price-to-earnings (or "P/E") ratio of 26.6x might 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 11x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

a2 Milk certainly has been doing a good job lately as its earnings growth has been positive while most other companies have been seeing their earnings go backwards. It seems that many are expecting the company to continue defying the broader market adversity, which has increased investors’ willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

View our latest analysis for a2 Milk

Want the full picture on analyst estimates for the company? Then our free report on a2 Milk will help you uncover what's on the horizon.

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

The only time you'd be truly comfortable seeing a P/E as high as a2 Milk's is when the company's growth is on track to outshine 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. Pleasingly, EPS has also lifted 113% in aggregate from three years ago, partly thanks to the last 12 months of growth. So we can start by confirming that the company has done a great job of growing earnings over that time.

Looking ahead now, EPS is anticipated to climb by 14% per annum during the coming three years according to the analysts following the company. With the market predicted to deliver 18% growth per year, the company is positioned for a weaker earnings result.

In light of this, it's alarming that a2 Milk's P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. 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.

What We Can Learn From a2 Milk's P/E?

Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

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. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

The company's balance sheet is another key area for risk analysis. You can assess many of the main risks through our free balance sheet analysis for a2 Milk with six simple checks.

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.