Tamagawa Holdings Co., Ltd.'s (TSE:6838) 32% Share Price Surge Not Quite Adding Up

Tamagawa Holdings Co., Ltd. (TSE:6838) shares have had a really impressive month, gaining 32% after a shaky period beforehand. Looking further back, the 13% rise over the last twelve months isn't too bad notwithstanding the strength over the last 30 days.

Following the firm bounce in price, given close to half the companies operating in Japan's Communications industry have price-to-sales ratios (or "P/S") below 0.7x, you may consider Tamagawa Holdings as a stock to potentially avoid with its 1.3x P/S ratio. However, the P/S might be high for a reason and it requires further investigation to determine if it's justified.

View our latest analysis for Tamagawa Holdings

What Does Tamagawa Holdings' P/S Mean For Shareholders?

With revenue growth that's exceedingly strong of late, Tamagawa Holdings has been doing very well. The P/S ratio is probably high because investors think this strong revenue growth will be enough to outperform the broader industry in the near future. However, if this isn't the case, investors might get caught out paying too much for the stock.

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 Tamagawa Holdings' earnings, revenue and cash flow.

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

There's an inherent assumption that a company should outperform the industry for P/S ratios like Tamagawa Holdings' to be considered reasonable.

Retrospectively, the last year delivered an exceptional 31% gain to the company's top line. However, this wasn't enough as the latest three year period has seen the company endure a nasty 40% drop in revenue in aggregate. Therefore, it's fair to say the revenue growth recently has been undesirable for the company.

In contrast to the company, the rest of the industry is expected to grow by 38% over the next year, which really puts the company's recent medium-term revenue decline into perspective.

With this in mind, we find it worrying that Tamagawa Holdings' P/S exceeds that of its industry peers. 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 revenue trends is likely to weigh heavily on the share price eventually.

The Final Word

The large bounce in Tamagawa Holdings' shares has lifted the company's P/S handsomely. We'd say the price-to-sales ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that Tamagawa Holdings currently trades on a much higher than expected P/S since its recent revenues have been in decline over the medium-term. With a revenue decline on investors' minds, the likelihood of a souring sentiment is quite high which could send the P/S back in line with what we'd expect. If recent medium-term revenue trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Plus, you should also learn about these 5 warning signs we've spotted with Tamagawa Holdings (including 2 which are a bit unpleasant).

Of course, profitable companies with a history of great earnings growth are generally safer bets. 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.