When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 16x, you may consider Nova Ltd. (NASDAQ:NVMI) as a stock to avoid entirely with its 28.9x 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.

With earnings growth that's superior to most other companies of late, Nova has been doing relatively well. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Check out our latest analysis for Nova

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 Nova's to be considered reasonable.

Taking a look back first, we see that the company managed to grow earnings per share by a handy 6.0% last year. Pleasingly, EPS has also lifted 181% in aggregate from three years ago, partly thanks to the last 12 months of growth. Therefore, it's fair to say the earnings growth recently has been superb for the company.

Shifting to the future, estimates from the five analysts covering the company suggest earnings growth is heading into negative territory, declining 6.6% over the next year. That's not great when the rest of the market is expected to grow by 10%.

With this information, we find it concerning that Nova is trading at a P/E higher than the market. Apparently many investors in the company reject the analyst cohort's pessimism and aren't willing to let go of their stock at any price. Only the boldest would assume these prices are sustainable as these declining earnings are likely to weigh heavily on the share price eventually.

The Final Word

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

Our examination of Nova's analyst forecasts revealed that its outlook for shrinking earnings isn't impacting its high P/E anywhere near as much as we would have predicted. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings are highly unlikely to support such positive sentiment for long. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

The company's balance sheet is another key area for risk analysis. Our free balance sheet analysis for Nova with six simple checks will allow you to discover any risks that could be an issue.

If you're unsure about the strength of Nova'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.