What Nihon Kagaku Sangyo Co., Ltd.'s (TSE:4094) 35% Share Price Gain Is Not Telling You

Nihon Kagaku Sangyo Co., Ltd. (TSE:4094) shares have had a really impressive month, gaining 35% after a shaky period beforehand. Looking back a bit further, it's encouraging to see the stock is up 31% in the last year.

After such a large jump in price, given around half the companies in Japan have price-to-earnings ratios (or "P/E's") below 13x, you may consider Nihon Kagaku Sangyo as a stock to potentially avoid with its 15.8x P/E ratio. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

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Nihon Kagaku Sangyo certainly has been doing a great job lately as it's been growing earnings at a really rapid pace. It seems that many are expecting the strong earnings performance to beat most other companies over the coming period, which has increased investors’ willingness to pay up for the stock. If not, then existing shareholders might be a little nervous about the viability of the share price.

View our latest analysis for Nihon Kagaku Sangyo

Although there are no analyst estimates available for Nihon Kagaku Sangyo, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.

Does Growth Match The High P/E?

In order to justify its P/E ratio, Nihon Kagaku Sangyo would need to produce impressive growth in excess of the market.

Retrospectively, the last year delivered an exceptional 43% gain to the company's bottom line. However, this wasn't enough as the latest three year period has seen a very unpleasant 22% drop in EPS 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 9.3% over the next year, which really puts the company's recent medium-term earnings decline into perspective.

In light of this, it's alarming that Nihon Kagaku Sangyo's P/E sits above the majority of other companies. 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

Nihon Kagaku Sangyo's P/E is getting right up there since its shares have risen strongly. Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

We've established that Nihon Kagaku Sangyo 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 Nihon Kagaku Sangyo with six simple checks.

Of course, you might also be able to find a better stock than Nihon Kagaku Sangyo. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.