Risks To Shareholder Returns Are Elevated At These Prices For Discovery Limited (JSE:DSY)

When close to half the companies in South Africa have price-to-earnings ratios (or "P/E's") below 9x, you may consider Discovery Limited (JSE:DSY) as a stock to avoid entirely with its 17.8x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

Discovery certainly has been doing a good job lately as it's been growing earnings more than most other companies. The P/E is probably high because investors think this strong earnings performance will continue. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

View our latest analysis for Discovery

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

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

There's an inherent assumption that a company should far outperform the market for P/E ratios like Discovery's to be considered reasonable.

Retrospectively, the last year delivered a decent 11% gain to the company's bottom line. This was backed up an excellent period prior to see EPS up by 125% in total over the last three years. So we can start by confirming that the company has done a great job of growing earnings over that time.

Turning to the outlook, the next three years should generate growth of 14% each year as estimated by the five analysts watching the company. Meanwhile, the rest of the market is forecast to expand by 14% each year, which is not materially different.

With this information, we find it interesting that Discovery is trading at a high P/E compared to the market. Apparently many investors in the company are more bullish than analysts indicate and aren't willing to let go of their stock right now. These shareholders may be setting themselves up for disappointment if the P/E falls to levels more in line with the growth outlook.

The Key Takeaway

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.

We've established that Discovery currently trades on a higher than expected P/E since its forecast growth is only in line with the wider market. 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. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

We don't want to rain on the parade too much, but we did also find 1 warning sign for Discovery that you need to be mindful of.

It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

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.