Investors Appear Satisfied With Cummins Inc.'s (NYSE:CMI) Prospects

Cummins Inc.'s (NYSE:CMI) price-to-earnings (or "P/E") ratio of 21.3x might make it look like a sell right now compared to the market in the United States, where around half of the companies have P/E ratios below 18x and even P/E's below 10x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

Recent times haven't been advantageous for Cummins as its earnings have been falling quicker than most other companies. One possibility is that the P/E is high because investors think the company will turn things around completely and accelerate past most others in the market. If not, then existing shareholders may be very nervous about the viability of the share price.

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Does Growth Match The High P/E?

The only time you'd be truly comfortable seeing a P/E as high as Cummins' is when the company's growth is on track to outshine the market.

Retrospectively, the last year delivered a frustrating 23% decrease to the company's bottom line. The last three years don't look nice either as the company has shrunk EPS by 5.4% in aggregate. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 19% per annum over the next three years. That's shaping up to be materially higher than the 10% per year growth forecast for the broader market.

With this information, we can see why Cummins is trading at such a high P/E compared to the market. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

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.

As we suspected, our examination of Cummins' analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. It's hard to see the share price falling strongly in the near future under these circumstances.

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

Of course, you might also be able to find a better stock than Cummins. 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.