When close to half the companies in Australia have price-to-earnings ratios (or "P/E's") below 17x, you may consider Australian Foundation Investment Company Limited (ASX:AFI) as a stock to avoid entirely with its 30.7x P/E ratio. 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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It looks like earnings growth has deserted Australian Foundation Investment recently, which is not something to boast about. One possibility is that the P/E is high because investors think the benign earnings growth will improve to outperform the broader market in the near future. If not, then existing shareholders may be a little nervous about the viability of the share price.

Check out our latest analysis for Australian Foundation Investment

Although there are no analyst estimates available for Australian Foundation Investment, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.

Does Growth Match The High P/E?

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

Retrospectively, the last year delivered virtually the same number to the company's bottom line as the year before. The lack of growth did nothing to help the company's aggregate three-year performance, which is an unsavory 1.8% drop in EPS. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Comparing that to the market, which is predicted to deliver 27% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.

With this information, we find it concerning that Australian Foundation Investment is trading at a P/E higher than the market. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the recent negative growth rates.

The Key Takeaway

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 Australian Foundation Investment currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. Right now we are increasingly uncomfortable with the high P/E as this earnings performance is highly unlikely to support such positive sentiment for long. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

We don't want to rain on the parade too much, but we did also find 1 warning sign for Australian Foundation Investment that you need to be mindful of.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on a low P/E.

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.