Avery Dennison Corporation's (NYSE:AVY) price-to-earnings (or "P/E") ratio of 33x might make it look like a strong sell right now compared to the market in the United States, where around half of the companies have P/E ratios below 16x and even P/E's below 9x are quite common. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

Recent times haven't been advantageous for Avery Dennison as its earnings have been falling quicker than most other companies. It might be that many expect the dismal earnings performance to recover substantially, which has kept the P/E from collapsing. 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 Avery Dennison's is when the company's growth is on track to outshine the market decidedly.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 40%. The last three years don't look nice either as the company has shrunk EPS by 5.1% in aggregate. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Turning to the outlook, the next three years should generate growth of 23% per year as estimated by the eleven analysts watching the company. Meanwhile, the rest of the market is forecast to only expand by 12% each year, which is noticeably less attractive.

In light of this, it's understandable that Avery Dennison's P/E sits above the majority of other companies. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Key Takeaway

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 Avery Dennison maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. It's hard to see the share price falling strongly in the near future under these circumstances.

You should always think about risks. Case in point, we've spotted 4 warning signs for Avery Dennison you should be aware of.

If these risks are making you reconsider your opinion on Avery Dennison, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.