With a price-to-earnings (or "P/E") ratio of 22.5x Valvoline Inc. (NYSE:VVV) may be sending 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 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.

With earnings growth that's superior to most other companies of late, Valvoline has been doing relatively well. The P/E is probably high because investors think this strong earnings performance will continue. 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 high as Valvoline's is when the company's growth is on track to outshine the market.

Taking a look back first, we see that the company grew earnings per share by an impressive 34% last year. The strong recent performance means it was also able to grow EPS by 52% in total over the last three years. So we can start by confirming that the company has done a great job of growing earnings over that time.

Looking ahead now, EPS is anticipated to slump, contracting by 5.0% during the coming year according to the analysts following the company. Meanwhile, the broader market is forecast to expand by 15%, which paints a poor picture.

With this information, we find it concerning that Valvoline is trading at a P/E higher than the market. Apparently many investors in the company reject the analyst cohort's pessimism and aren't willing to let go of their stock at any price. There's a very good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the negative growth outlook.

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.

Our examination of Valvoline's analyst forecasts revealed that its outlook for shrinking earnings isn't impacting its high P/E anywhere near as much as we would have predicted. When we see a poor outlook with earnings heading backwards, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Don't forget that there may be other risks. For instance, we've identified 1 warning sign for Valvoline that you should be aware of.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on a low P/E.

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