Unpleasant Surprises Could Be In Store For Tata Elxsi Limited's (NSE:TATAELXSI) Shares
Tata Elxsi Limited's (NSE:TATAELXSI) price-to-earnings (or "P/E") ratio of 54.4x might make it look like a strong sell right now compared to the market in India, where around half of the companies have P/E ratios below 25x and even P/E's below 14x are quite common. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's so lofty.
Tata Elxsi hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. It might be that many expect the dour earnings performance to recover substantially, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.
Check out our latest analysis for Tata Elxsi
Is There Enough Growth For Tata Elxsi?
There's an inherent assumption that a company should far outperform the market for P/E ratios like Tata Elxsi's to be considered reasonable.
If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 18%. Unfortunately, that's brought it right back to where it started three years ago with EPS growth being virtually non-existent overall during that time. Accordingly, shareholders probably wouldn't have been overly satisfied with the unstable medium-term growth rates.
Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 14% each year over the next three years. That's shaping up to be materially lower than the 20% each year growth forecast for the broader market.
In light of this, it's alarming that Tata Elxsi's P/E sits above the majority of other companies. 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 good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.
The Final Word
While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.
We've established that Tata Elxsi currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.
Many other vital risk factors can be found on the company's balance sheet. Take a look at our free balance sheet analysis for Tata Elxsi with six simple checks on some of these key factors.
Of course, you might also be able to find a better stock than Tata Elxsi. 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.