When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 16x, you may consider Aehr Test Systems (NASDAQ:AEHR) as a stock to avoid entirely with its 38.5x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

Recent times have been quite advantageous for Aehr Test Systems as its earnings have been rising very briskly. The P/E is probably high because investors think this strong earnings growth will be enough to outperform the broader market in the near future. If not, then existing shareholders might be a little nervous about the viability of the share price.

Check out our latest analysis for Aehr Test Systems

Does Growth Match The High P/E?

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

Taking a look back first, we see that the company grew earnings per share by an impressive 90% last year. However, the latest three year period hasn't been as great in aggregate as it didn't manage to provide any growth at all. Therefore, it's fair to say that earnings growth has been inconsistent recently for the company.

Weighing that recent medium-term earnings trajectory against the broader market's one-year forecast for expansion of 10% shows it's noticeably less attractive on an annualised basis.

With this information, we find it concerning that Aehr Test Systems is trading at a P/E higher than the market. 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. Only the boldest would assume these prices are sustainable as a continuation of recent earnings trends is likely to weigh heavily on the share price eventually.

The Key Takeaway

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.

Our examination of Aehr Test Systems 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. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

Having said that, be aware Aehr Test Systems is showing 3 warning signs in our investment analysis, and 1 of those is concerning.

If these risks are making you reconsider your opinion on Aehr Test Systems, 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.