When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 16x, you may consider Dolby Laboratories, Inc. (NYSE:DLB) as a stock to avoid entirely with its 39.9x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

With earnings that are retreating more than the market's of late, Dolby Laboratories has been very sluggish. One possibility is that the P/E is high because investors think the company will turn things around completely and accelerate past most others in the market. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

How Is Dolby Laboratories' Growth Trending?

The only time you'd be truly comfortable seeing a P/E as steep as Dolby Laboratories' is when the company's growth is on track to outshine the market decidedly.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 20%. The last three years don't look nice either as the company has shrunk EPS by 34% in aggregate. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Turning to the outlook, the next year should generate growth of 34% as estimated by the three analysts watching the company. Meanwhile, the rest of the market is forecast to only expand by 12%, which is noticeably less attractive.

With this information, we can see why Dolby Laboratories is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Bottom Line On Dolby Laboratories' P/E

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.

We've established that Dolby Laboratories maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. Unless these conditions change, they will continue to provide strong support to the share price.

A lot of potential risks can sit within a company's balance sheet. Our free balance sheet analysis for Dolby Laboratories with six simple checks will allow you to discover any risks that could be an issue.

You might be able to find a better investment than Dolby Laboratories. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

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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.

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