Technology One Limited's (ASX:TNE) 27% Share Price Surge Not Quite Adding Up

The Technology One Limited (ASX:TNE) share price has done very well over the last month, posting an excellent gain of 27%. The annual gain comes to 103% following the latest surge, making investors sit up and take notice.

After such a large jump in price, you could be forgiven for thinking Technology One is a stock to steer clear of with a price-to-sales ratios (or "P/S") of 19.6x, considering almost half the companies in Australia's Software industry have P/S ratios below 3.1x. However, the P/S might be quite high for a reason and it requires further investigation to determine if it's justified.

View our latest analysis for Technology One

What Does Technology One's P/S Mean For Shareholders?

Technology One could be doing better as it's been growing revenue less than most other companies lately. Perhaps the market is expecting future revenue performance to undergo a reversal of fortunes, which has elevated the P/S ratio. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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

Is There Enough Revenue Growth Forecasted For Technology One?

In order to justify its P/S ratio, Technology One would need to produce outstanding growth that's well in excess of the industry.

Retrospectively, the last year delivered an exceptional 18% gain to the company's top line. The strong recent performance means it was also able to grow revenue by 63% in total over the last three years. Accordingly, shareholders would have definitely welcomed those medium-term rates of revenue growth.

Looking ahead now, revenue is anticipated to climb by 15% per annum during the coming three years according to the analysts following the company. That's shaping up to be materially lower than the 20% each year growth forecast for the broader industry.

With this information, we find it concerning that Technology One is trading at a P/S higher than the industry. 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. Only the boldest would assume these prices are sustainable as this level of revenue growth is likely to weigh heavily on the share price eventually.

The Key Takeaway

The strong share price surge has lead to Technology One's P/S soaring as well. We'd say the price-to-sales ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've concluded that Technology One currently trades on a much higher than expected P/S since its forecast growth is lower than the wider industry. The weakness in the company's revenue estimate doesn't bode well for the elevated P/S, which could take a fall if the revenue sentiment doesn't improve. At these price levels, investors should remain cautious, particularly if things don't improve.

The company's balance sheet is another key area for risk analysis. You can assess many of the main risks through our free balance sheet analysis for Technology One with six simple checks.

It's important to make sure you look for a great company, not just the first idea you come across. So if growing profitability aligns with your idea of a great company, take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

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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.