Focusrite plc's (LON:TUNE) 26% Share Price Surge Not Quite Adding Up

Those holding Focusrite plc (LON:TUNE) shares would be relieved that the share price has rebounded 26% in the last thirty days, but it needs to keep going to repair the recent damage it has caused to investor portfolios. Unfortunately, the gains of the last month did little to right the losses of the last year with the stock still down 30% over that time.

After such a large jump in price, given around half the companies in the United Kingdom have price-to-earnings ratios (or "P/E's") below 17x, you may consider Focusrite as a stock to potentially avoid with its 19.3x P/E ratio. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.

Focusrite has been struggling lately as its earnings have declined faster 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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What Are Growth Metrics Telling Us About The High P/E?

In order to justify its P/E ratio, Focusrite would need to produce impressive growth in excess of the market.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 40%. The last three years don't look nice either as the company has shrunk EPS by 45% 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 bring diminished returns, with earnings decreasing 3.1% per annum as estimated by the four analysts watching the company. That's not great when the rest of the market is expected to grow by 15% each year.

With this information, we find it concerning that Focusrite is trading at a P/E higher than the market. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. There's a very good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the negative growth outlook.

The Final Word

The large bounce in Focusrite's shares has lifted the company's P/E to a fairly high level. Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

We've established that Focusrite currently trades on a much higher than expected P/E for a company whose earnings are forecast to decline. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings are highly unlikely to support such positive sentiment for long. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Focusrite, and understanding these should be part of your investment process.

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