With a price-to-earnings (or "P/E") ratio of 13.1x NagaCorp Ltd. (HKG:3918) may be sending bearish signals at the moment, given that almost half of all companies in Hong Kong have P/E ratios under 9x and even P/E's lower than 5x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

With earnings growth that's superior to most other companies of late, NagaCorp 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.

Does Growth Match The High P/E?

There's an inherent assumption that a company should outperform the market for P/E ratios like NagaCorp's to be considered reasonable.

Taking a look back first, we see that the company grew earnings per share by an impressive 66% last year. The latest three year period has also seen an excellent 74% overall rise in EPS, aided by its short-term performance. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 20% per annum as estimated by the six analysts watching the company. That's shaping up to be materially higher than the 16% per annum growth forecast for the broader market.

In light of this, it's understandable that NagaCorp's P/E sits above the majority of other companies. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Key Takeaway

We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that NagaCorp maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. Unless these conditions change, they will continue to provide strong support to the share price.

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

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