Reece Limited's (ASX:REH) 27% Share Price Plunge Could Signal Some Risk

To the annoyance of some shareholders, Reece Limited (ASX:REH) shares are down a considerable 27% in the last month, which continues a horrid run for the company. Instead of being rewarded, shareholders who have already held through the last twelve months are now sitting on a 40% share price drop.

In spite of the heavy fall in price, Reece's price-to-earnings (or "P/E") ratio of 28.9x might still 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 17x and even P/E's below 10x 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.

Reece hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. It might be that many expect the dour 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.

View our latest analysis for Reece

If you'd like to see what analysts are forecasting going forward, you should check out our free report on Reece.

How Is Reece's Growth Trending?

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

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 11%. That put a dampener on the good run it was having over the longer-term as its three-year EPS growth is still a noteworthy 18% in total. Accordingly, while they would have preferred to keep the run going, shareholders would be roughly satisfied with the medium-term rates of earnings growth.

Shifting to the future, estimates from the twelve analysts covering the company suggest earnings should grow by 9.6% each year over the next three years. That's shaping up to be materially lower than the 15% per annum growth forecast for the broader market.

With this information, we find it concerning that Reece is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. 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.

The Final Word

Reece's shares may have retreated, but its P/E is still flying high. 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.

Our examination of Reece's analyst forecasts revealed that its inferior earnings outlook isn't impacting its high P/E anywhere near as much as we would have predicted. 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.

Having said that, be aware Reece is showing 1 warning sign in our investment analysis, you should know about.

You might be able to find a better investment than Reece. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

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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.