REA Group Limited's (ASX:REA) price-to-earnings (or "P/E") ratio of 51.4x might make it look like a strong sell right now compared to the market in Australia, where around half of the companies have P/E ratios below 18x and even P/E's below 11x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

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Recent times have been advantageous for REA Group as its earnings have been rising faster than most other companies. 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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Does Growth Match The High P/E?

REA Group's P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.

Retrospectively, the last year delivered an exceptional 119% gain to the company's bottom line. Pleasingly, EPS has also lifted 67% in aggregate from three years ago, thanks to the last 12 months of growth. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Looking ahead now, EPS is anticipated to climb by 9.0% per year during the coming three years according to the analysts following the company. That's shaping up to be materially lower than the 15% per annum growth forecast for the broader market.

In light of this, it's alarming that REA Group'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. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

What We Can Learn From REA Group's P/E?

Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that REA Group 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. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

The company's balance sheet is another key area for risk analysis. Take a look at our free balance sheet analysis for REA Group with six simple checks on some of these key factors.

If P/E ratios interest you, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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