With a price-to-earnings (or "P/E") ratio of 15.6x Capital Southwest Corporation (NASDAQ:CSWC) 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 35x are not unusual. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's limited.

Capital Southwest has been struggling lately as its earnings have declined faster than most other companies. It seems that many are expecting the dismal earnings performance to persist, which has repressed the P/E. You'd much rather the company wasn't bleeding earnings if you still believe in the business. If not, then existing shareholders will probably struggle to get excited about the future direction of the share price.

How Is Capital Southwest's Growth Trending?

In order to justify its P/E ratio, Capital Southwest would need to produce sluggish growth that's trailing the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 12%. This means it has also seen a slide in earnings over the longer-term as EPS is down 9.7% in total over the last three years. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 12% per year as estimated by the seven analysts watching the company. Meanwhile, the rest of the market is forecast to expand by 11% each year, which is not materially different.

In light of this, it's peculiar that Capital Southwest'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 Key Takeaway

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.

We've established that Capital Southwest 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. At least the risk of a price drop looks to be subdued, but investors seem to think future earnings could see some volatility.

There are also other vital risk factors to consider and we've discovered 4 warning signs for Capital Southwest (2 can't be ignored!) that you should be aware of before investing here.

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.