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It's not a stretch to say that Orica Limited's (ASX:ORI) price-to-earnings (or "P/E") ratio of 18.2x right now seems quite "middle-of-the-road" compared to the market in Australia, where the median P/E ratio is around 17x. Although, it's not wise to simply ignore the P/E without explanation as investors may be disregarding a distinct opportunity or a costly mistake.
Orica certainly has been doing a good job lately as its earnings growth has been positive while most other companies have been seeing their earnings go backwards. It might be that many expect the strong earnings performance to deteriorate like the rest, which has kept the P/E from rising. If you like the company, you'd be hoping this isn't the case so that you could potentially pick up some stock while it's not quite in favour.
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Does Growth Match The P/E?
In order to justify its P/E ratio, Orica would need to produce growth that's similar to the market.
Taking a look back first, we see that the company grew earnings per share by an impressive 74% last year. Despite this strong recent growth, it's still struggling to catch up as its three-year EPS frustratingly shrank by 5.1% overall. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.
Turning to the outlook, the next three years should generate growth of 3.0% per year as estimated by the eleven analysts watching the company. With the market predicted to deliver 13% growth per annum, the company is positioned for a weaker earnings result.
In light of this, it's curious that Orica's P/E sits in line with the majority of other companies. It seems most investors are ignoring the fairly limited growth expectations and are willing to pay up for exposure to the stock. Maintaining these prices will be difficult to achieve as this level of earnings growth is likely to weigh down the shares eventually.
The Key Takeaway
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.
We've established that Orica currently trades on a higher than expected P/E since its forecast growth is lower than the wider market. Right now we are uncomfortable with the P/E as the predicted future earnings aren't likely to support a more positive sentiment for long. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.