There's Reason For Concern Over Power Solutions, Ltd.'s (TSE:4450) Massive 27% Price Jump

Despite an already strong run, Power Solutions, Ltd. (TSE:4450) shares have been powering on, with a gain of 27% in the last thirty days. Looking back a bit further, it's encouraging to see the stock is up 86% in the last year.

Following the firm bounce in price, Power Solutions' price-to-earnings (or "P/E") ratio of 19.7x 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 14x and even P/E's below 10x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

Trump has pledged to "unleash" American oil and gas and these 15 US stocks have developments that are poised to benefit.

Earnings have risen firmly for Power Solutions recently, which is pleasing to see. One possibility is that the P/E is high because investors think this respectable earnings growth will be enough to outperform the broader market in the near future. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

See our latest analysis for Power Solutions

Want the full picture on earnings, revenue and cash flow for the company? Then our free report on Power Solutions will help you shine a light on its historical performance.

How Is Power Solutions' Growth Trending?

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

If we review the last year of earnings growth, the company posted a worthy increase of 7.7%. Ultimately though, it couldn't turn around the poor performance of the prior period, with EPS shrinking 2.8% in total over the last three years. 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 11% 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 Power Solutions' 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. Only the boldest would assume these prices are sustainable as a continuation of recent earnings trends is likely to weigh heavily on the share price eventually.

The Final Word

Power Solutions shares have received a push in the right direction, but its P/E is elevated too. It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

Our examination of Power Solutions revealed its shrinking earnings over the medium-term aren't impacting its high P/E anywhere near as much as we would have predicted, given the market is set to grow. 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.

You should always think about risks. Case in point, we've spotted 2 warning signs for Power Solutions you should be aware of, and 1 of them is potentially serious.

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

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.