Disco Corporation (TSE:6146) shares have had a really impressive month, gaining 26% after a shaky period beforehand. The last 30 days bring the annual gain to a very sharp 28%.
Since its price has surged higher, Disco may be sending very bearish signals at the moment with a price-to-earnings (or "P/E") ratio of 44x, since almost half of all companies in Japan have P/E ratios under 14x and even P/E's lower than 10x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.
With earnings growth that's superior to most other companies of late, Disco has been doing relatively well. The P/E is probably high because investors think this strong earnings performance will continue. If not, then existing shareholders might be a little nervous about the viability of the share price.
View our latest analysis for Disco
How Is Disco's Growth Trending?
In order to justify its P/E ratio, Disco would need to produce outstanding growth well in excess of the market.
If we review the last year of earnings growth, the company posted a terrific increase of 30%. The strong recent performance means it was also able to grow EPS by 73% in total over the last three years. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.
Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 9.9% per year over the next three years. Meanwhile, the rest of the market is forecast to expand by 9.6% per annum, which is not materially different.
With this information, we find it interesting that Disco 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 Key Takeaway
Shares in Disco 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 Disco 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. Unless these conditions improve, it's challenging to accept these prices as being reasonable.
Before you take the next step, you should know about the 1 warning sign for Disco that we have uncovered.
If you're unsure about the strength of Disco's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.
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