Prada S.p.A.'s (HKG:1913) price-to-earnings (or "P/E") ratio of 16.7x might make it look like a sell right now compared to the market in Hong Kong, where around half of the companies have P/E ratios below 11x and even P/E's below 6x are quite common. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.

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With earnings growth that's superior to most other companies of late, Prada has been doing relatively well. The P/E is probably high because investors think this strong earnings performance will continue. If not, then existing shareholders might be a little nervous about the viability of the share price.

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How Is Prada's Growth Trending?

There's an inherent assumption that a company should outperform the market for P/E ratios like Prada's to be considered reasonable.

If we review the last year of earnings growth, the company posted a terrific increase of 25%. The strong recent performance means it was also able to grow EPS by 185% in total over the last three years. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 9.6% per year over the next three years. Meanwhile, the rest of the market is forecast to expand by 15% per annum, which is noticeably more attractive.

In light of this, it's alarming that Prada's P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. Only the boldest would assume these prices are sustainable as this level of earnings growth is likely to weigh heavily on the share price eventually.

The Key Takeaway

We'd say 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 Prada currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, 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.

It is also worth noting that we have found 1 warning sign for Prada that you need to take into consideration.

If you're unsure about the strength of Prada's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.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.