When close to half the companies in India have price-to-earnings ratios (or "P/E's") below 26x, you may consider Rama Steel Tubes Limited (NSE:RAMASTEEL) as a stock to avoid entirely with its 76x 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.
For instance, Rama Steel Tubes' receding earnings in recent times would have to be some food for thought. 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.
Check out our latest analysis for Rama Steel Tubes
Is There Enough Growth For Rama Steel Tubes?
The only time you'd be truly comfortable seeing a P/E as steep as Rama Steel Tubes' is when the company's growth is on track to outshine the market decidedly.
If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 61%. The last three years don't look nice either as the company has shrunk EPS by 36% in aggregate. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.
In contrast to the company, the rest of the market is expected to grow by 24% over the next year, which really puts the company's recent medium-term earnings decline into perspective.
With this information, we find it concerning that Rama Steel Tubes is trading at a P/E higher than the market. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. 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 Final Word
We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.
We've established that Rama Steel Tubes 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.
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 Rama Steel Tubes 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 take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).
Valuation is complex, but we're here to simplify it.
Discover if Rama Steel Tubes might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.
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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.