Megastar Foods Limited's (NSE:MEGASTAR) 27% Share Price Surge Not Quite Adding Up

Megastar Foods Limited (NSE:MEGASTAR) shareholders would be excited to see that the share price has had a great month, posting a 27% gain and recovering from prior weakness. Taking a wider view, although not as strong as the last month, the full year gain of 13% is also fairly reasonable.

After such a large jump in price, given close to half the companies in India have price-to-earnings ratios (or "P/E's") below 27x, you may consider Megastar Foods as a stock to avoid entirely with its 64.1x 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.

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As an illustration, earnings have deteriorated at Megastar Foods over the last year, which is not ideal at all. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

View our latest analysis for Megastar Foods

Although there are no analyst estimates available for Megastar Foods, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.

Does Growth Match The High P/E?

Megastar Foods' P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 3.6%. The last three years don't look nice either as the company has shrunk EPS by 17% in aggregate. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Comparing that to the market, which is predicted to deliver 25% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.

In light of this, it's alarming that Megastar Foods' 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. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the recent negative growth rates.

The Key Takeaway

The strong share price surge has got Megastar Foods' P/E rushing to great heights as well. 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 Megastar Foods currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. When we see earnings heading backwards and underperforming the market forecasts, 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.

You should always think about risks. Case in point, we've spotted 4 warning signs for Megastar Foods you should be aware of, and 1 of them is potentially serious.

It's important to make sure you look for a great company, not just the first idea you come across. So 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.