FRONTEO, Inc.'s (TSE:2158) Shares Climb 26% But Its Business Is Yet to Catch Up

The FRONTEO, Inc. (TSE:2158) share price has done very well over the last month, posting an excellent gain of 26%. Taking a wider view, although not as strong as the last month, the full year gain of 10% is also fairly reasonable.

After such a large jump in price, when almost half of the companies in Japan's IT industry have price-to-sales ratios (or "P/S") below 1.1x, you may consider FRONTEO as a stock not worth researching with its 3.8x P/S ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/S.

View our latest analysis for FRONTEO

How FRONTEO Has Been Performing

FRONTEO certainly has been doing a good job lately as it's been growing revenue more than most other companies. The P/S is probably high because investors think this strong revenue performance will continue. However, if this isn't the case, investors might get caught out paying too much for the stock.

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

What Are Revenue Growth Metrics Telling Us About The High P/S?

In order to justify its P/S ratio, FRONTEO would need to produce outstanding growth that's well in excess of the industry.

Taking a look back first, we see that the company managed to grow revenues by a handy 14% last year. Still, lamentably revenue has fallen 29% in aggregate from three years ago, which is disappointing. Therefore, it's fair to say the revenue growth recently has been undesirable for the company.

Looking ahead now, revenue is anticipated to slump, contracting by 8.5% during the coming year according to the one analyst following the company. Meanwhile, the broader industry is forecast to expand by 5.5%, which paints a poor picture.

With this in mind, we find it intriguing that FRONTEO's P/S is closely matching its industry peers. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. There's a very good chance these shareholders are setting themselves up for future disappointment if the P/S falls to levels more in line with the negative growth outlook.

What We Can Learn From FRONTEO's P/S?

The strong share price surge has lead to FRONTEO's P/S soaring as well. While the price-to-sales ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of revenue expectations.

We've established that FRONTEO currently trades on a much higher than expected P/S for a company whose revenues are forecast to decline. Right now we aren't comfortable with the high P/S as the predicted future revenue decline likely to impact the positive sentiment that's propping up the P/S. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

You should always think about risks. Case in point, we've spotted 1 warning sign for FRONTEO you should be aware of.

If strong companies turning a profit tickle your fancy, then you'll want to check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

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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.