Investors Appear Satisfied With Southwest Airlines Co.'s (NYSE:LUV) Prospects As Shares Rocket 32%

Southwest Airlines Co. (NYSE:LUV) shares have had a really impressive month, gaining 32% after a shaky period beforehand. Taking a wider view, although not as strong as the last month, the full year gain of 17% is also fairly reasonable.

Since its price has surged higher, Southwest Airlines may be sending very bearish signals at the moment with a price-to-earnings (or "P/E") ratio of 34x, since almost half of all companies in the United States have P/E ratios under 18x and even P/E's lower than 10x are not unusual. 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.

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With earnings growth that's superior to most other companies of late, Southwest Airlines has been doing relatively well. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.

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

In order to justify its P/E ratio, Southwest Airlines would need to produce outstanding growth well in excess of the market.

If we review the last year of earnings growth, the company posted a terrific increase of 39%. However, this wasn't enough as the latest three year period has seen a very unpleasant 2.5% drop in EPS in aggregate. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 54% each year as estimated by the analysts watching the company. That's shaping up to be materially higher than the 10% per annum growth forecast for the broader market.

With this information, we can see why Southwest Airlines is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Bottom Line On Southwest Airlines' P/E

Southwest Airlines' P/E is flying high just like its stock has during the last month. 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 Southwest Airlines maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. It's hard to see the share price falling strongly in the near future under these circumstances.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 1 warning sign with Southwest Airlines, and understanding should be part of your investment process.

If these risks are making you reconsider your opinion on Southwest Airlines, 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.