With a price-to-earnings (or "P/E") ratio of 25.7x Federal Signal Corporation (NYSE:FSS) may be sending bearish signals at the moment, given that almost half of all companies in the United States have P/E ratios under 18x and even P/E's lower than 11x are not unusual. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

Recent times have been advantageous for Federal Signal as its earnings have been rising faster 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.

Does Growth Match The High P/E?

The only time you'd be truly comfortable seeing a P/E as high as Federal Signal's is when the company's growth is on track to outshine the market.

If we review the last year of earnings growth, the company posted a terrific increase of 45%. The strong recent performance means it was also able to grow EPS by 97% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been superb for the company.

Looking ahead now, EPS is anticipated to climb by 5.7% during the coming year according to the seven analysts following the company. Meanwhile, the rest of the market is forecast to expand by 15%, which is noticeably more attractive.

In light of this, it's alarming that Federal Signal's P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

What We Can Learn From Federal Signal's P/E?

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 Federal Signal currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Having said that, be aware Federal Signal is showing 1 warning sign in our investment analysis, you should know about.

If you're unsure about the strength of Federal Signal's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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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.