What NEXTDC Limited's (ASX:NXT) P/S Is Not Telling You

When you see that almost half of the companies in the IT industry in Australia have price-to-sales ratios (or "P/S") below 1.4x, NEXTDC Limited (ASX:NXT) looks to be giving off strong sell signals with its 22.8x P/S ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/S.

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Check out our latest analysis for NEXTDC

How NEXTDC Has Been Performing

While the industry has experienced revenue growth lately, NEXTDC's revenue has gone into reverse gear, which is not great. It might be that many expect the dour revenue performance to recover substantially, which has kept the P/S from collapsing. However, if this isn't the case, investors might get caught out paying too much for the stock.

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How Is NEXTDC's Revenue Growth Trending?

The only time you'd be truly comfortable seeing a P/S as steep as NEXTDC's is when the company's growth is on track to outshine the industry decidedly.

In reviewing the last year of financials, we were disheartened to see the company's revenues fell to the tune of 2.7%. However, a few very strong years before that means that it was still able to grow revenue by an impressive 49% in total over the last three years. So we can start by confirming that the company has generally done a very good job of growing revenue over that time, even though it had some hiccups along the way.

Shifting to the future, estimates from the analysts covering the company suggest revenue should grow by 21% per year over the next three years. That's shaping up to be similar to the 23% each year growth forecast for the broader industry.

With this in consideration, we find it intriguing that NEXTDC's P/S is higher than its industry peers. It seems most investors are ignoring the fairly average growth expectations and are willing to pay up for exposure to the stock. Although, additional gains will be difficult to achieve as this level of revenue growth is likely to weigh down the share price eventually.

The Final Word

Generally, our preference is to limit the use of the price-to-sales ratio to establishing what the market thinks about the overall health of a company.

Analysts are forecasting NEXTDC's revenues to only grow on par with the rest of the industry, which has lead to the high P/S ratio being unexpected. The fact that the revenue figures aren't setting the world alight has us doubtful that the company's elevated P/S can be sustainable for the long term. A positive change is needed in order to justify the current price-to-sales ratio.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 3 warning signs with NEXTDC (at least 2 which don't sit too well with us), and understanding them should be part of your investment process.

If these risks are making you reconsider your opinion on NEXTDC, 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.