AutoNation, Inc.'s (NYSE:AN) price-to-earnings (or "P/E") ratio of 5.9x might make it look like a strong buy right now compared to the market in the United States, where around half of the companies have P/E ratios above 17x and even P/E's above 33x 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 so limited.

AutoNation hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. The P/E is probably low because investors think this poor earnings performance isn't going to get any better. If this is the case, then existing shareholders will probably struggle to get excited about the future direction of the share price.

View our latest analysis for AutoNation

How Is AutoNation's Growth Trending?

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

Retrospectively, the last year delivered a frustrating 4.5% decrease to the company's bottom line. Even so, admirably EPS has lifted 489% in aggregate from three years ago, notwithstanding the last 12 months. Accordingly, while they would have preferred to keep the run going, shareholders would probably welcome the medium-term rates of earnings growth.

Turning to the outlook, the next three years should bring diminished returns, with earnings decreasing 2.7% per year as estimated by the ten analysts watching the company. That's not great when the rest of the market is expected to grow by 13% each year.

With this information, we are not surprised that AutoNation is trading at a P/E lower than the market. However, shrinking earnings are unlikely to lead to a stable P/E over the longer term. There's potential for the P/E to fall to even lower levels if the company doesn't improve its profitability.

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.

As we suspected, our examination of AutoNation's analyst forecasts revealed that its outlook for shrinking earnings is contributing to its low P/E. Right now shareholders are accepting the low P/E as they concede future earnings probably won't provide any pleasant surprises. Unless these conditions improve, they will continue to form a barrier for the share price around these levels.

You always need to take note of risks, for example - AutoNation has 2 warning signs we think you should be aware of.

Of course, you might also be able to find a better stock than AutoNation. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.