With a price-to-earnings (or "P/E") ratio of 12.2x XP Inc. (NASDAQ:XP) may be sending bullish signals at the moment, given that almost half of all companies in the United States have P/E ratios greater than 19x and even P/E's higher than 34x are not unusual. However, the P/E might be low for a reason and it requires further investigation to determine if it's justified.

Recent times have been pleasing for XP as its earnings have risen in spite of the market's earnings going into reverse. One possibility is that the P/E is low because investors think the company's earnings are going to fall away like everyone else's soon. If you like the company, you'd be hoping this isn't the case so that you could potentially pick up some stock while it's out of favour.

Does Growth Match The Low P/E?

There's an inherent assumption that a company should underperform the market for P/E ratios like XP's to be considered reasonable.

Retrospectively, the last year delivered an exceptional 18% gain to the company's bottom line. The latest three year period has also seen an excellent 58% overall rise in EPS, aided by its short-term performance. So we can start by confirming that the company has done a great job of growing earnings over that time.

Shifting to the future, estimates from the nine analysts covering the company suggest earnings should grow by 10% per year over the next three years. Meanwhile, the rest of the market is forecast to expand by 10% per year, which is not materially different.

In light of this, it's peculiar that XP's P/E sits below the majority of other companies. Apparently some shareholders are doubtful of the forecasts and have been accepting lower selling prices.

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.

We've established that XP currently trades on a lower than expected P/E since its forecast growth is in line with the wider market. When we see an average earnings outlook with market-like growth, we assume potential risks are what might be placing pressure on the P/E ratio. It appears some are indeed anticipating earnings instability, because these conditions should normally provide more support to the share price.

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

It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

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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.