Earnings Not Telling The Story For Sumitomo Chemical India Limited (NSE:SUMICHEM) After Shares Rise 25%

Sumitomo Chemical India Limited (NSE:SUMICHEM) shareholders have had their patience rewarded with a 25% share price jump in the last month. The last 30 days bring the annual gain to a very sharp 26%.

Since its price has surged higher, given close to half the companies in India have price-to-earnings ratios (or "P/E's") below 29x, you may consider Sumitomo Chemical India 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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Sumitomo Chemical India certainly has been doing a good job lately as it's been growing earnings more than most other companies. The P/E is probably high because investors think this strong earnings performance will continue. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

View our latest analysis for Sumitomo Chemical India

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How Is Sumitomo Chemical India's Growth Trending?

There's an inherent assumption that a company should far outperform the market for P/E ratios like Sumitomo Chemical India's to be considered reasonable.

Taking a look back first, we see that the company grew earnings per share by an impressive 37% last year. The latest three year period has also seen a 19% overall rise in EPS, aided extensively by its short-term performance. Accordingly, shareholders would have probably been satisfied with the medium-term rates of earnings growth.

Shifting to the future, estimates from the five analysts covering the company suggest earnings should grow by 18% per annum over the next three years. That's shaping up to be materially lower than the 22% per year growth forecast for the broader market.

In light of this, it's alarming that Sumitomo Chemical India's P/E sits above the majority of other companies. 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. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

What We Can Learn From Sumitomo Chemical India's P/E?

Shares in Sumitomo Chemical India have built up some good momentum lately, which has really inflated its P/E. 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 Sumitomo Chemical India currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Many other vital risk factors can be found on the company's balance sheet. Take a look at our free balance sheet analysis for Sumitomo Chemical India with six simple checks on some of these key factors.

You might be able to find a better investment than Sumitomo Chemical India. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (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.