More Unpleasant Surprises Could Be In Store For Castro Model Ltd.'s (TLV:CAST) Shares After Tumbling 25%

The Castro Model Ltd. (TLV:CAST) share price has fared very poorly over the last month, falling by a substantial 25%. 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, given close to half the companies in Israel have price-to-earnings ratios (or "P/E's") below 9x, you may still consider Castro Model as a stock to avoid entirely with its 17.5x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

As an illustration, earnings have deteriorated at Castro Model over the last year, which is not ideal at all. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. If not, then existing shareholders may be quite nervous about the viability of the share price.

Check out the opportunities and risks within the IL Specialty Retail industry.

We don't have analyst forecasts, but you can see how recent trends are setting up the company for the future by checking out our free report on Castro Model's earnings, revenue and cash flow.

Does Growth Match The High P/E?

The only time you'd be truly comfortable seeing a P/E as steep as Castro Model's is when the company's growth is on track to outshine the market decidedly.

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 65%. At least EPS has managed not to go completely backwards from three years ago in aggregate, thanks to the earlier period of growth. So it appears to us that the company has had a mixed result in terms of growing earnings over that time.

Weighing that recent medium-term earnings trajectory against the broader market's one-year forecast for expansion of 15% shows it's noticeably less attractive on an annualised basis.

In light of this, it's alarming that Castro Model's P/E sits above the majority of other companies. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. Only the boldest would assume these prices are sustainable as a continuation of recent earnings trends is likely to weigh heavily on the share price eventually.

The Final Word

Even after such a strong price drop, Castro Model's P/E still exceeds the rest of the market significantly. 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.

We've established that Castro Model currently trades on a much higher than expected P/E since its recent three-year growth is lower than the wider market forecast. When we see weak earnings with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. If recent medium-term earnings trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

It is also worth noting that we have found 3 warning signs for Castro Model (1 makes us a bit uncomfortable!) that you need to take into consideration.

You might be able to find a better investment than Castro Model. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a P/E below 20x (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.