With a price-to-earnings (or "P/E") ratio of 25.4x Gates Industrial Corporation plc (NYSE:GTES) may be sending bearish signals at the moment, given that almost half of all companies in the United States have P/E ratios under 19x and even P/E's lower than 11x are not unusual. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

Gates Industrial hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. One possibility is that the P/E is high because investors think this poor earnings performance will turn the corner. 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, Gates Industrial would need to produce impressive growth in excess of 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 8.1%. This means it has also seen a slide in earnings over the longer-term as EPS is down 1.9% in total over the last three years. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Looking ahead now, EPS is anticipated to climb by 26% per annum during the coming three years according to the nine analysts following the company. That's shaping up to be materially higher than the 11% per annum growth forecast for the broader market.

With this information, we can see why Gates Industrial 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 Gates Industrial'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. It's hard to see the share price falling strongly in the near future under these circumstances.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 1 warning sign with Gates Industrial, and understanding should be part of your investment process.

Of course, you might also be able to find a better stock than Gates Industrial. 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.