ASX Limited's (ASX:ASX) price-to-earnings (or "P/E") ratio of 27.1x might make it look like a sell right now compared to the market in Australia, where around half of the companies have P/E ratios below 19x and even P/E's below 11x 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.

ASX certainly has been doing a good job lately as it's been growing earnings more than most other companies. The P/E is probably high because investors think this strong earnings performance will continue. If not, then existing shareholders might be a little nervous about the viability of the share price.

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Keen to find out how analysts think ASX's future stacks up against the industry? In that case, our free report is a great place to start.

How Is ASX's Growth Trending?

In order to justify its P/E ratio, ASX would need to produce impressive growth in excess of the market.

Retrospectively, the last year delivered an exceptional 49% gain to the company's bottom line. Despite this strong recent growth, it's still struggling to catch up as its three-year EPS frustratingly shrank by 1.5% overall. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Turning to the outlook, the next three years should generate growth of 3.6% per year as estimated by the analysts watching the company. With the market predicted to deliver 19% growth per year, the company is positioned for a weaker earnings result.

With this information, we find it concerning that ASX is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. Only the boldest would assume these prices are sustainable as this level of earnings growth is likely to weigh heavily on the share price eventually.

The Key Takeaway

While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

We've established that ASX currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

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

Of course, you might also be able to find a better stock than ASX. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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