Unpleasant Surprises Could Be In Store For Advanced Drainage Systems, Inc.'s (NYSE:WMS) Shares

Advanced Drainage Systems, Inc.'s (NYSE:WMS) price-to-earnings (or "P/E") ratio of 26.5x might make it look like a strong sell right now compared to the market in the United States, where around half of the companies have P/E ratios below 17x and even P/E's below 9x are quite common. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's so lofty.

Advanced Drainage Systems 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. 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 Advanced Drainage Systems

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Does Growth Match The High P/E?

Advanced Drainage Systems' P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.

Retrospectively, the last year delivered a decent 5.8% gain to the company's bottom line. This was backed up an excellent period prior to see EPS up by 149% in total over the last three years. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Looking ahead now, EPS is anticipated to climb by 12% each year during the coming three years according to the eight analysts following the company. Meanwhile, the rest of the market is forecast to expand by 9.9% per annum, which is not materially different.

With this information, we find it interesting that Advanced Drainage Systems is trading at a high P/E compared to the market. 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 Key Takeaway

Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that Advanced Drainage Systems currently trades on a higher than expected P/E since its forecast growth is only in line with the wider market. When we see an average earnings outlook with market-like growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless these conditions improve, it's challenging to accept these prices as being reasonable.

There are also other vital risk factors to consider before investing and we've discovered 2 warning signs for Advanced Drainage Systems that you should be aware of.

You might be able to find a better investment than Advanced Drainage Systems. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

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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.