After Leaping 32% SMS Co., Ltd. (TSE:2175) Shares Are Not Flying Under The Radar

SMS Co., Ltd. (TSE:2175) shares have had a really impressive month, gaining 32% after a shaky period beforehand. Unfortunately, the gains of the last month did little to right the losses of the last year with the stock still down 38% over that time.

After such a large jump in price, given around half the companies in Japan have price-to-earnings ratios (or "P/E's") below 12x, you may consider SMS as a stock to potentially avoid with its 18.5x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

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SMS hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. It might be that many expect the dour earnings performance to recover substantially, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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Is There Enough Growth For SMS?

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

Retrospectively, the last year delivered a frustrating 14% decrease to the company's bottom line. This has soured the latest three-year period, which nevertheless managed to deliver a decent 15% overall rise in EPS. Accordingly, while they would have preferred to keep the run going, shareholders would be roughly satisfied with the medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 15% per year as estimated by the seven analysts watching the company. That's shaping up to be materially higher than the 9.8% each year growth forecast for the broader market.

With this information, we can see why SMS is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Bottom Line On SMS' P/E

The large bounce in SMS' shares has lifted the company's P/E to a fairly high level. Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that SMS maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. Unless these conditions change, they will continue to provide strong support to the share price.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with SMS, and understanding them should be part of your investment process.

If these risks are making you reconsider your opinion on SMS, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.