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It's not a stretch to say that CML Microsystems plc's (LON:CML) price-to-earnings (or "P/E") ratio of 17.5x right now seems quite "middle-of-the-road" compared to the market in the United Kingdom, where the median P/E ratio is around 16x. While this might not raise any eyebrows, if the P/E ratio is not justified investors could be missing out on a potential opportunity or ignoring looming disappointment.
As an illustration, earnings have deteriorated at CML Microsystems over the last year, which is not ideal at all. One possibility is that the P/E is moderate because investors think the company might still do enough to be in line with the broader market in the near future. If not, then existing shareholders may be a little nervous about the viability of the share price.
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Does Growth Match The P/E?
CML Microsystems' P/E ratio would be typical for a company that's only expected to deliver moderate growth, and importantly, perform in line with the market.
If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 43%. This means it has also seen a slide in earnings over the longer-term as EPS is down 61% in total over the last three years. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.
Comparing that to the market, which is predicted to shrink 8.5% in the next 12 months, the company's downward momentum is still inferior based on recent medium-term annualised earnings results.
In light of this, it's somewhat peculiar that CML Microsystems' P/E sits in line with the majority of other companies. With earnings going quickly in reverse, it's not guaranteed that the P/E has found a floor yet. Maintaining these prices will be difficult to achieve as a continuation of recent earnings trends is likely to weigh down the shares eventually.
The Key Takeaway
Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.
We've established that CML Microsystems currently trades on a higher than expected P/E since its recent three-year earnings are even worse than the forecasts for a struggling market. Right now we are uncomfortable with the P/E as this earnings performance isn't likely to support a more positive sentiment for long. In addition, we would be concerned whether the company can even maintain its medium-term level of performance under these tough market conditions. This would place shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.