Australian Foundation Investment Company Limited's (ASX:AFI) price-to-earnings (or "P/E") ratio of 32x might make it look like a strong 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. 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.

For example, consider that Australian Foundation Investment's financial performance has been poor lately as its earnings have been in decline. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Check out our latest analysis for Australian Foundation Investment

We don't have analyst forecasts, but you can see how recent trends are setting up the company for the future by checking out our free report on Australian Foundation Investment's earnings, revenue and cash flow.

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 Australian Foundation Investment's to be considered reasonable.

Retrospectively, the last year delivered a frustrating 5.2% decrease to the company's bottom line. That put a dampener on the good run it was having over the longer-term as its three-year EPS growth is still a noteworthy 22% in total. So we can start by confirming that the company has generally done a good job of growing earnings over that time, even though it had some hiccups along the way.

Comparing that to the market, which is predicted to deliver 25% growth in the next 12 months, the company's momentum is weaker based on recent medium-term annualised earnings results.

In light of this, it's alarming that Australian Foundation Investment's P/E sits above the majority of other companies. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. There's a good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with recent growth rates.

The Final Word

Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

Our examination of Australian Foundation Investment revealed its three-year earnings trends aren't impacting its high P/E anywhere near as much as we would have predicted, given they look worse than current market expectations. Right now we are increasingly uncomfortable with the high P/E as this earnings performance isn't likely to support such positive sentiment for long. If recent medium-term earnings trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

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.

If P/E ratios interest you, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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