Direct Digital Holdings, Inc. (NASDAQ:DRCT) shareholders won't be pleased to see that the share price has had a very rough month, dropping 31% and undoing the prior period's positive performance. Still, a bad month hasn't completely ruined the past year with the stock gaining 41%, which is great even in a bull market.

Although its price has dipped substantially, given around half the companies in the United States have price-to-earnings ratios (or "P/E's") below 17x, you may still consider Direct Digital Holdings as a stock to potentially avoid with its 24.2x P/E ratio. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.

For example, consider that Direct Digital Holdings' financial performance has been poor lately as its earnings have been in decline. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Does Growth Match The High P/E?

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

Retrospectively, the last year delivered a frustrating 58% decrease to the company's bottom line. At least EPS has managed not to go completely backwards from three years ago in aggregate, thanks to the earlier period of growth. Accordingly, shareholders probably wouldn't have been overly satisfied with the unstable medium-term growth rates.

Weighing that recent medium-term earnings trajectory against the broader market's one-year forecast for expansion of 14% shows it's noticeably less attractive on an annualised basis.

In light of this, it's alarming that Direct Digital Holdings' P/E sits above the majority of other companies. It seems most investors are ignoring the fairly limited recent growth rates and are hoping for a turnaround in the company's business prospects. There's a good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with recent growth rates.

The Key Takeaway

There's still some solid strength behind Direct Digital Holdings' P/E, if not its share price lately. Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

We've established that Direct Digital Holdings currently trades on a much higher than expected P/E since its recent three-year growth is lower than the wider market forecast. When we see weak earnings with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

You need to take note of risks, for example - Direct Digital Holdings has 4 warning signs (and 2 which are significant) we think you should know about.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on 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.