There's Reason For Concern Over MegaChips Corporation's (TSE:6875) Massive 27% Price Jump

MegaChips Corporation (TSE:6875) shares have had a really impressive month, gaining 27% after a shaky period beforehand. Looking further back, the 18% rise over the last twelve months isn't too bad notwithstanding the strength over the last 30 days.

After such a large jump in price, MegaChips' price-to-earnings (or "P/E") ratio of 19.6x might make it look like a sell right now compared to the market in Japan, where around half of the companies have P/E ratios below 13x and even P/E's below 9x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

While the market has experienced earnings growth lately, MegaChips' earnings have gone into reverse gear, which is not great. 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.

See our latest analysis for MegaChips

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Is There Enough Growth For MegaChips?

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

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 34%. As a result, earnings from three years ago have also fallen 74% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Shifting to the future, estimates from the four analysts covering the company suggest earnings should grow by 11% each year over the next three years. With the market predicted to deliver 9.4% growth per annum, the company is positioned for a comparable earnings result.

With this information, we find it interesting that MegaChips is trading at a high P/E compared to the market. It seems most investors are ignoring the fairly average growth expectations and are willing to pay up for exposure to the stock. These shareholders may be setting themselves up for disappointment if the P/E falls to levels more in line with the growth outlook.

What We Can Learn From MegaChips' P/E?

MegaChips shares have received a push in the right direction, but its P/E is elevated too. 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.

Our examination of MegaChips' analyst forecasts revealed that its market-matching earnings outlook isn't impacting its high P/E as much as we would have predicted. 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 2 warning signs for MegaChips that we have uncovered.

Of course, you might also be able to find a better stock than MegaChips. 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.