Alphabet Inc.’s (NASDAQ:GOOGL) price-to-earnings (or “P/E”) ratio of 17.9x 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 13x and even P/E’s below 8x are quite common. Nonetheless, we’d need to dig a little deeper to determine if there is a rational basis for the elevated P/E.
Recent times have been advantageous for Alphabet as its earnings have been rising faster than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. You’d really hope so, otherwise you’re paying a pretty hefty price for no particular reason.
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There’s an inherent assumption that a company should outperform the market for P/E ratios like Alphabet’s to be considered reasonable.
Retrospectively, the last year delivered an exceptional 17% gain to the company’s bottom line. The strong recent performance means it was also able to grow EPS by 121% in total over the last three years. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.
Turning to the outlook, the next three years should generate growth of 11% each year as estimated by the analysts watching the company. With the market predicted to deliver 9.7% growth per year, the company is positioned for a comparable earnings result.
With this information, we find it interesting that Alphabet is trading at a high P/E compared to the market. Apparently many investors in the company are more bullish than analysts indicate and aren’t willing to let go of their stock right now. These shareholders may be setting themselves up for disappointment if the P/E falls to levels more in line with the growth outlook.
It’s argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.
We’ve established that Alphabet 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.
A lot of potential risks can sit within a company’s balance sheet. Our free balance sheet analysis for Alphabet with six simple checks will allow you to discover any risks that could be an issue.
If you’re unsure about the strength of Alphabet’s business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
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