Allegro MicroSystems, Inc. (NASDAQ:ALGM) Stock Rockets 25% As Investors Are Less Pessimistic Than Expected

Allegro MicroSystems, Inc. (NASDAQ:ALGM) shares have had a really impressive month, gaining 25% after a shaky period beforehand. Unfortunately, the gains of the last month did little to right the losses of the last year with the stock still down 28% over that time.

Following the firm bounce in price, given close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 16x, you may consider Allegro MicroSystems as a stock to avoid entirely with its 28.3x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

Allegro MicroSystems 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.

Check out our latest analysis for Allegro MicroSystems

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

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

There's an inherent assumption that a company should far outperform the market for P/E ratios like Allegro MicroSystems' to be considered reasonable.

Taking a look back first, we see that the company grew earnings per share by an impressive 44% last year. The strong recent performance means it was also able to grow EPS by 96% 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 slump, contracting by 4.4% per year during the coming three years according to the eight analysts following the company. That's not great when the rest of the market is expected to grow by 11% per annum.

In light of this, it's alarming that Allegro MicroSystems' 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 very good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the negative growth outlook.

The Key Takeaway

The strong share price surge has got Allegro MicroSystems' P/E rushing to great heights as well. 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 Allegro MicroSystems currently trades on a much higher than expected P/E for a company whose earnings are forecast to decline. When we see a poor outlook with earnings heading backwards, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Plus, you should also learn about this 1 warning sign we've spotted with Allegro MicroSystems.

If these risks are making you reconsider your opinion on Allegro MicroSystems, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.