Shofu Inc.'s (TSE:7979) 26% Share Price Surge Not Quite Adding Up

The Shofu Inc. (TSE:7979) share price has done very well over the last month, posting an excellent gain of 26%. The annual gain comes to 118% following the latest surge, making investors sit up and take notice.

Following the firm bounce in price, given close to half the companies in Japan have price-to-earnings ratios (or "P/E's") below 13x, you may consider Shofu as a stock to avoid entirely with its 20.9x P/E ratio. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's so lofty.

With earnings growth that's superior to most other companies of late, Shofu has been doing relatively well. 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 Shofu

Keen to find out how analysts think Shofu's future stacks up against the industry? In that case, our free report is a great place to start.

How Is Shofu's Growth Trending?

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

Retrospectively, the last year delivered an exceptional 53% gain to the company's bottom line. Pleasingly, EPS has also lifted 73% in aggregate from three years ago, thanks to the last 12 months of growth. Therefore, it's fair to say the earnings growth recently has been superb for the company.

Turning to the outlook, the next three years should generate growth of 11% per year as estimated by the three analysts watching the company. That's shaping up to be similar to the 9.4% each year growth forecast for the broader market.

With this information, we find it interesting that Shofu is trading at a high P/E compared to the market. Apparently many investors in the company are more bullish than analysts indicate and aren't willing to let go of their stock right now. Although, additional gains will be difficult to achieve as this level of earnings growth is likely to weigh down the share price eventually.

The Bottom Line On Shofu's P/E

Shofu's P/E is flying high just like its stock has during the last month. 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 Shofu currently trades on a higher than expected P/E since its forecast growth is only in line with the wider market. When we see an average earnings outlook with market-like growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

You should always think about risks. Case in point, we've spotted 2 warning signs for Shofu you should be aware of.

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

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.