When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 18x, you may consider Digi International Inc. (NASDAQ:DGII) as a stock to avoid entirely with its 47.6x 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.

While the market has experienced earnings growth lately, Digi International's earnings have gone into reverse gear, which is not great. It might be that many expect the dour earnings performance to recover substantially, which has kept the P/E from collapsing. If not, then existing shareholders may be extremely 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 steep as Digi International's is when the company's growth is on track to outshine the market decidedly.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 10%. Still, the latest three year period has seen an excellent 91% overall rise in EPS, in spite of its unsatisfying short-term performance. Although it's been a bumpy ride, it's still fair to say the earnings growth recently has been more than adequate for the company.

Shifting to the future, estimates from the five analysts covering the company suggest earnings should grow by 55% over the next year. That's shaping up to be materially higher than the 15% growth forecast for the broader market.

With this information, we can see why Digi International is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Key Takeaway

While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

As we suspected, our examination of Digi International's analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. It's hard to see the share price falling strongly in the near future under these circumstances.

Plus, you should also learn about this 1 warning sign we've spotted with Digi International.

If you're unsure about the strength of Digi International'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.