Espressif Systems (Shanghai) Co., Ltd.'s (SHSE:688018) price-to-earnings (or "P/E") ratio of 50.6x might make it look like a strong sell right now compared to the market in China, where around half of the companies have P/E ratios below 29x and even P/E's below 18x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

Espressif Systems (Shanghai) certainly has been doing a good job lately as it's been growing earnings more than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.

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 Espressif Systems (Shanghai)'s to be considered reasonable.

If we review the last year of earnings growth, the company posted a terrific increase of 59%. As a result, it also grew EPS by 26% in total over the last three years. So we can start by confirming that the company has actually done a good job of growing earnings over that time.

Looking ahead now, EPS is anticipated to climb by 27% per annum during the coming three years according to the six analysts following the company. Meanwhile, the rest of the market is forecast to only expand by 21% per annum, which is noticeably less attractive.

With this information, we can see why Espressif Systems (Shanghai) is trading at such a high P/E compared to the market. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

The Final Word

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.

As we suspected, our examination of Espressif Systems (Shanghai)'s analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. Unless these conditions change, they will continue to provide strong support to the share price.

It is also worth noting that we have found 1 warning sign for Espressif Systems (Shanghai) that you need to take into consideration.

If these risks are making you reconsider your opinion on Espressif Systems (Shanghai), 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.