More Unpleasant Surprises Could Be In Store For Nelco Limited's (NSE:NELCO) Shares After Tumbling 26%

Nelco Limited (NSE:NELCO) shares have retraced a considerable 26% in the last month, reversing a fair amount of their solid recent performance. Looking at the bigger picture, even after this poor month the stock is up 29% in the last year.

Although its price has dipped substantially, Nelco's price-to-sales (or "P/S") ratio of 7.3x might still make it look like a strong sell right now compared to other companies in the Communications industry in India, where around half of the companies have P/S ratios below 3.3x and even P/S below 1x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/S.

Check out our latest analysis for Nelco

How Nelco Has Been Performing

It looks like revenue growth has deserted Nelco recently, which is not something to boast about. One possibility is that the P/S is high because investors think the benign revenue growth will improve to outperform the broader industry in the near future. However, if this isn't the case, investors might get caught out paying too much for the stock.

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 Nelco's earnings, revenue and cash flow.

Do Revenue Forecasts Match The High P/S Ratio?

There's an inherent assumption that a company should far outperform the industry for P/S ratios like Nelco's to be considered reasonable.

If we review the last year of revenue, the company posted a result that saw barely any deviation from a year ago. Fortunately, a few good years before that means that it was still able to grow revenue by 26% in total over the last three years. Therefore, it's fair to say that revenue growth has been inconsistent recently for the company.

Comparing that to the industry, which is predicted to deliver 32% growth in the next 12 months, the company's momentum is weaker, based on recent medium-term annualised revenue results.

With this information, we find it concerning that Nelco is trading at a P/S higher than the industry. 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 good chance existing shareholders are setting themselves up for future disappointment if the P/S falls to levels more in line with recent growth rates.

The Bottom Line On Nelco's P/S

Even after such a strong price drop, Nelco's P/S still exceeds the industry median significantly. Generally, our preference is to limit the use of the price-to-sales ratio to establishing what the market thinks about the overall health of a company.

Our examination of Nelco revealed its poor three-year revenue trends aren't detracting from the P/S as much as we though, given they look worse than current industry expectations. Right now we aren't comfortable with the high P/S as this revenue performance isn't likely to support such positive sentiment for long. If recent medium-term revenue trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

There are also other vital risk factors to consider before investing and we've discovered 1 warning sign for Nelco that you should be aware of.

If strong companies turning a profit tickle your fancy, then you'll want to check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.