Lithia Motors, Inc.'s (NYSE:LAD) price-to-earnings (or "P/E") ratio of 7.6x might make it look like a strong buy right now compared to the market in the United States, where around half of the companies have P/E ratios above 17x and even P/E's above 32x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly reduced P/E.

Recent times haven't been advantageous for Lithia Motors as its earnings have been falling quicker than most other companies. The P/E is probably low because investors think this poor earnings performance isn't going to improve at all. You'd much rather the company wasn't bleeding earnings if you still believe in the business. Or at the very least, you'd be hoping the earnings slide doesn't get any worse if your plan is to pick up some stock while it's out of favour.

Is There Any Growth For Lithia Motors?

In order to justify its P/E ratio, Lithia Motors would need to produce anemic growth that's substantially trailing the market.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 17%. However, a few very strong years before that means that it was still able to grow EPS by an impressive 45% in total over the last three years. So we can start by confirming that the company has generally done a very good job of growing earnings over that time, even though it had some hiccups along the way.

Looking ahead now, EPS is anticipated to climb by 10% per annum during the coming three years according to the analysts following the company. With the market predicted to deliver 10.0% growth each year, the company is positioned for a comparable earnings result.

In light of this, it's peculiar that Lithia Motors' P/E sits below the majority of other companies. It may be that most investors are not convinced the company can achieve future growth expectations.

The Final Word

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.

Our examination of Lithia Motors' analyst forecasts revealed that its market-matching earnings outlook isn't contributing to its P/E as much as we would have predicted. 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.

Having said that, be aware Lithia Motors is showing 1 warning sign in our investment analysis, you should know about.

Of course, you might also be able to find a better stock than Lithia Motors. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.