Despite an already strong run, Energy Recovery, Inc. (NASDAQ:ERII) shares have been powering on, with a gain of 27% in the last thirty days. Unfortunately, the gains of the last month did little to right the losses of the last year with the stock still down 33% over that time.

After such a large jump in price, given close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 18x, you may consider Energy Recovery as a stock to avoid entirely with its 51.2x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

With its earnings growth in positive territory compared to the declining earnings of most other companies, Energy Recovery has been doing quite well of late. 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.

Does Growth Match The High P/E?

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

Taking a look back first, we see that the company grew earnings per share by an impressive 92% last year. As a result, it also grew EPS by 20% in total over the last three years. So we can start by confirming that the company has actually done a good job of growing earnings over that time.

Looking ahead now, EPS is anticipated to climb by 29% each year during the coming three years according to the four analysts following the company. With the market only predicted to deliver 10% per year, the company is positioned for a stronger earnings result.

With this information, we can see why Energy Recovery is trading at such a high P/E compared to the market. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

What We Can Learn From Energy Recovery's P/E?

Shares in Energy Recovery have built up some good momentum lately, which has really inflated its P/E. It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

As we suspected, our examination of Energy Recovery's 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. Unless these conditions change, they will continue to provide strong support to the share price.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Energy Recovery, and understanding these should be part of your investment process.

If these risks are making you reconsider your opinion on Energy Recovery, explore our interactive list of high quality stocks to get an idea of what else is out there.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.