What Tomen Devices Corporation's (TSE:2737) 28% Share Price Gain Is Not Telling You

Tomen Devices Corporation (TSE:2737) shareholders have had their patience rewarded with a 28% share price jump in the last month. While recent buyers may be laughing, long-term holders might not be as pleased since the recent gain only brings the stock back to where it started a year ago.

Following the firm bounce in price, given close to half the companies in Japan have price-to-earnings ratios (or "P/E's") below 14x, you may consider Tomen Devices as a stock to avoid entirely with its 34.7x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

For example, consider that Tomen Devices' financial performance has been poor lately as its earnings have been in decline. One possibility is that the P/E is high because investors think the company will still do 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.

View our latest analysis for Tomen Devices

We don't have analyst forecasts, but you can see how recent trends are setting up the company for the future by checking out our free report on Tomen Devices' earnings, revenue and cash flow.

Does Growth Match The High P/E?

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

Retrospectively, the last year delivered a frustrating 73% decrease to the company's bottom line. As a result, earnings from three years ago have also fallen 60% overall. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

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 Tomen Devices' 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

Tomen Devices' P/E is flying high just like its stock has during the last month. Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that Tomen Devices 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.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 3 warning signs with Tomen Devices, and understanding them should be part of your investment process.

You might be able to find a better investment than Tomen Devices. If you want a selection of possible candidates, 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.