With a price-to-earnings (or "P/E") ratio of 50.4x Synopsys, Inc. (NASDAQ:SNPS) may be sending very bearish signals at the moment, given that almost half of all companies in the United States have P/E ratios under 18x and even P/E's lower than 10x are not unusual. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

Synopsys certainly has been doing a good job lately as its earnings growth has been positive while most other companies have been seeing their earnings go backwards. It seems that many are expecting the company to continue defying the broader market adversity, which has increased investors' willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

How Is Synopsys' Growth Trending?

In order to justify its P/E ratio, Synopsys would need to produce outstanding growth well in excess of the market.

Retrospectively, the last year delivered an exceptional 46% gain to the company's bottom line. The strong recent performance means it was also able to grow EPS by 99% in total over the last three years. 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 13% each year as estimated by the analysts watching the company. With the market only predicted to deliver 11% each year, the company is positioned for a stronger earnings result.

With this information, we can see why Synopsys 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

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.

As we suspected, our examination of Synopsys' analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. It's hard to see the share price falling strongly in the near future under these circumstances.

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

If P/E ratios interest you, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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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.