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With a price-to-earnings (or "P/E") ratio of 45.6x Luna Innovations Incorporated (NASDAQ:LUNA) 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.
Luna Innovations certainly has been doing a great job lately as it's been growing earnings at a really rapid pace. It seems that many are expecting the strong earnings performance to beat most other companies over the coming period, 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.
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Does Growth Match The High P/E?
The only time you'd be truly comfortable seeing a P/E as steep as Luna Innovations' is when the company's growth is on track to outshine the market decidedly.
If we review the last year of earnings growth, the company posted a terrific increase of 74%. Still, EPS has barely risen at all from three years ago in total, which is not ideal. Accordingly, shareholders probably wouldn't have been overly satisfied with the unstable medium-term growth rates.
This is in contrast to the rest of the market, which is expected to grow by 3.2% over the next year, materially higher than the company's recent medium-term annualised growth rates.
With this information, we find it concerning that Luna Innovations is trading at a P/E higher than the market. It seems most investors are ignoring the fairly limited recent growth rates and are hoping for a turnaround in the company's business prospects. There's a good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with recent growth rates.
The Key Takeaway
The price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.
We've established that Luna Innovations currently trades on a much higher than expected P/E since its recent three-year growth is lower than the wider market forecast. When we see weak earnings with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.